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EU’s grand hydrogen project at odds with market competition principle

Europe's gas grid operators are perfectly placed to kickstart a new market for decarbonized gas – apart from the small detail of regulation that prevents them controlling both supply and transmission assets. Silvia Favasuli examines a new conundrum for EU energy regulation.

From Spain's Enagas to Portugal's Galp to Italy's Snam, European gas transmission system operators are planning moves beyond their traditional activities, eyeing active participation in decarbonized gas production projects.

Several TSOs have already signed preliminary deals to develop large hydrogen production projects and invest in biomethane facilities. Among the initiatives, Spain's large-scale hydrogen production project stands out. Named HyDeal Ambition, it involves the participation of 30 European companies including energy suppliers, renewable technology developers and five TSOs, including Spain's incumbent, Enagas. The others are Snam, Germany's OGE, and France's GRTgaz and Terega.

These forays into decarbonized gas are generally still at an early stage but could test a core principle of EU energy regulation: unbundling, or the structural separation of supply and transportation operations. So far, the flurry of activity has not triggered a public reaction by the European Commission raising questions about its commitment to this key tenet of Europe's free and competitive energy markets.

The requirement for gas and power TSOs to be independent from production and supply activities was introduced in the Third Energy Package (2009), and aimed to avoid vertically integrated incumbents using their monopoly on the transmission networks to suffocate the emergence of new suppliers or frustrate their competitors' growth.

The EU's ideal of competitive energy markets has been restated and strengthened over the years and became one of the pillars of the Energy Union Strategy launched in 2015, which aimed for further integration of member states' energy systems.

It is considered so important that the Union has worked hard to promote the approach even outside its borders, for example asking Ukraine to unbundle its gas supply and transportation operations as part of the Association Agreement signed by Kiev and the EU in 2017.

Decarbonization and the market

But earlier priorities around free and efficient trade in energy have run up against the need to quickly establish a new sector with high start-up costs.

The EC may have pushed itself into a corner by setting the ambitious target of reaching climate neutrality by 2050, and even more ambitious hydrogen goals: to reach renewable hydrogen electrolysis capacity totaling 6 GW by 2024, and 40 GW by 2030.

Go deeper: Learn more about S&P Global Platts Analytics hydrogen coverage

With commercial production of hydrogen and biomethane still on a small scale, the development of a market for decarbonized gas relies on a combination of private investment and state aid plans to bring production technology costs down and make the price of green gases competitive against fossil-based alternatives. While market-based solutions already exist, these may not be fast enough to meet targets within the set time.

For example, carbon prices are still far from the levels required to make hydrogen profitable versus fossil fuels. EUAs have recently been around Eur38/mt-39/mt, and the general consensus is that a level of Eur60/mt would be needed to make hydrogen competitive against other fossil fuels.

Also, with large-scale electrolyzers currently very expensive – the cost of a 1 GW electrolyzer is around Eur1 billion - companies might only be willing to invest if profit is ensured and risks eliminated, argues Jonathan Stern, distinguished research fellow at the Oxford Institute for Energy Studies.

"People would invest if they think they can have a monopoly. If they know they have to compete, and money may not be there, forget about it," Stern said.

Against these valid arguments, the EC will also have to be wary of distorting competition while working to achieve its energy and climate targets.

"At the moment it feels like the EC is aiming to reach its decarbonization targets as soon as possible, and then worry about the impact on consumers later," said an industry stakeholder looking closely at hydrogen regulation who spoke on condition of anonymity.

"But once a TSOs has invested in a production site, it won't be easy to take it away from them," the same gas industry source said.

The involvement of TSOs in green gas production may also discourage other smaller and newer players from getting involved:

"The risk is that no other players will come up, even in this exploratory phase, so this will translate in less liquidity in the market tomorrow," OIES' Stern said.

Cautious approach

The EC has so far made no public statement on the need to preserve the unbundling principle in hydrogen or decarb gas markets. Energy industry stakeholders are awaiting an update of the EU Energy Directive by the end of 2021, in which the EC should decide whether hydrogen and decarbonized gas will continue to fall under natural gas regulation or have their own separate rules.

In a letter sent to Europe's regulator ACER in October and seen by Platts, the Directorate General Energy asked ACER to make sure that the provisions of the Gas Directive are respected when it comes to hydrogen and biomethane production projects.

"The production of hydrogen is considered to be subject to the rules of the Gas Directive in accordance with Article 1, paragraph 2 therof, which states that the Directive shall apply also to 'other types of gas in so far such gases can technically and safely be injected into, and transported through, the natural gas system'," the letter says.

An EC officer who in February spoke with Platts via email on condition of anonymity confirmed that Brussels is currently considering the Gas Directive provisions as applying to investments by TSOs in hydrogen and biomethane production.

The officer added: "TSOs can [only] hold passive minority participations in companies active in the production of hydrogen or bio-methane (i.e. rights to dividends only; no voting rights or rights to appoint board members) and electricity TSOs can request exemptions for the ownership/operation of electrolyzers subject to the fulfilment of several condition (Article 54 Electricity Directive)," he said.

In the absence of a public position, national energy regulators and TSOs have reacted in different ways. In some countries, such as Germany, regulators stepped up to fill the gap and have already started to set limits and boundaries by themselves. Others, like Italy or Spain, are taking a wait-and-see approach, and seem to be allowing their TSOs to push the boundaries towards rules more favorable to them.

"At the moment, Spanish TSOs and DSOs [distribution system operators] do not infringe unbundling rules, as the projects are still in the R&D phase," a spokesperson from Spanish regulator, CNMC, said.

"In the meantime, the Gas Directive is going to be revised, and exceptions for these cases might be introduced. Nevertheless, when the project reaches the operational phase, Enagas will have the option to disinvest," the spokesperson said.

In Italy, president of energy regulator ARERA, Stefano Basseghini, told La Repubblica Feb. 8 that it would be normal to see the largest energy companies, including TSOs, getting involved in the exploratory phase of hydrogen, and that at the moment he did not envisage any real threat to the principle of unbundling.

Meanwhile, a Snam spokesman said the TSO intends to "implement its hydrogen projects by strictly abiding to unbundling rules as set in the Directive 2009/73/EC."

Snam had so far said in its 2020-2024 investment plan that it intends to continue investing in the hydrogen value chain, including taking an upstream position should there be long-term supply contracts in place.

Risk of monopolies developing

While existing gas and power networks are considered essential facilities controlled by natural monopolists and therefore in need of regulation, there is no certainty that pure-hydrogen networks would be set up in a similar way.

As ACER noted in a white paper published Feb. 9, pure-hydrogen grids could develop as small and local networks, or become large and interconnected enough for their owners to be considered natural monopolies.

But since both hydrogen and biomethane can technically be already injected into existing gas grids, an active participation of gas TSOs in the production and marketing of decarbonized gases is already a threat to competition.

The need to have a CO2-free gas to inject into their existing grids, which could help preserve their core business in an age of energy transition, is the very reason why gas TSOs are so actively pushing for the development of hydrogen and decarbonized gas markets.

Snam, Europe's largest gas TSOs and possibly the most active company across Europe in hydrogen development, even envisions for Italy the role of a hydrogen transport hub between North Africa – which the TSOs considers a source of cheap green hydrogen production – and the rest of Europe.

It is not by chance that in a second white paper published on Feb. 11, ACER suggested the EC limit the role of network operators to decarbonized gas transmission and distribution services, and allow their participation in production projects only in exceptional cases, to be approved by local regulators under clear and limited conditions.

Hybrid solutions needed

The current debate around developing decarbonized gas and hydrogen markets at scale reveals three key needs: on the gas TSOs' part, to see this new market succeed as a means of securing their own future in a low-carbon world; on the EU's side, to achieve its climate targets; and for consumers, to have access to energy at competitive prices.

Some industry participants are already advancing hybrid solutions as a way of meeting these requirements.

"There have been some German players advancing the idea of hybrid hydrogen production facilities, which may work in a very similar way of LNG terminals," said Andris Piebalgs, a professor at the Florence School of regulation who also served as a European Commissioner for Energy between 2004 and 2009.

"Under this model, a TSOs could own the electrolyzer but not the production capacity, which instead would have to be marketed through transparent auctions, exactly as it happens with regasification capacity in an LNG terminal," Piebalgs said.

Another solution could be to set a temporary exemption from the principle of ownership unbundling, says Nicolas Jensen, senior policy advisor at Eurogas.

"The role of regulated operators is that of neutral market facilitators. Production activities should remain strictly a market-based activity. Exceptions may exist, for a limited time and to be reassessed through regular market tests, that could allow regulated operators to invest sporadically, only if the market does not pick up by itself," Jensen said.

But perhaps, the best argument supporting the need to preserve the ownership unbundling principle across new green energy markets comes from the present.

Despite having technically achieved unbundling in the natural gas sector, in many countries in the bloc, especially in Southern Europe, historic arrangements for supply and transport are proving hard to shift. This might be a warning for those undertaking market design to last the next 30 years and beyond.

This content has been corrected to clarify that Nicolas Jensen was suggesting a temporary exemption from the principle of ownership unbundling rather than a suspension.