3.1 Introduction
PRICE RISKS
Historically oil and gas prices have been correlated, though with a lag, so that the risk of price shocks in oil or gas are clearly interdependent. As a result, moving dependence from gas to oil or vice versa cannot significantly reduce an economy’s exposure to a price shock affecting either fuel. At present gas technologies are the most competitive fossil-fuel form of electricity generation in Ireland and in the immediate future all new thermal generation plant is likely to be gas-fired. The alternatives to increasing gas dependence are coal, nuclear and wind, which have higher capital costs and face other problems (including higher environmental costs, especially for coal and nuclear). Under these circumstances, positive policy intervention to change the fuel shares used in electricity generation will have significant costs. The fact that gas dependence continues to increase in Europe should be seen as evidence that fuel diversity in the power generation industry comes at a price. Electricity generation historically has tended to go through periods lasting
24 Where the supply pipelines pass through a limited number of countries, such as
decades when, driven by technological developments, one fuel appears far more attractive than the rest.
However, if Ireland were more affected than other markets by the price shock, then there would be a loss of competitiveness relative to our EU partners. Such a loss would compound the loss of output and income, with an increased incentive for sensitive production to move to other locations that were less affected by the shock. In the case of businesses, the loss of competitiveness relative to similar electricity-using businesses abroad could be significantly greater, given the much greater gas dependence of the electricity sector in Ireland compared to the rest of the EU. This could be further compounded if they were heavy users of oil and gas, as well as of electricity. Thus, the income loss as a result of a price shock would be aggravated by an enhanced incentive to relocate electricity intensive output elsewhere.25
There is a range of different strategies that could be adopted to reduce dependence on gas, or on any one other fuel. Unlike the case of a physical interruption, there would be limited incentive for individual firms with generating plant to take the risk of a major shock to gas prices into account in their investment decisions. Because all producers in Ireland (and elsewhere) would be faced with the same increase, in the long run they could pass it on fully to consumers. While there would be some small reduction in demand due to the higher prices, this would be limited and profitability would not suffer dramatically. It is only if the price rise were sustained for many years that investment in new plant using alternative fuels would take place, stranding existing gas plant. In the end the suppliers of gas, if acting rationally, would ensure that prices did not remain high for so long that their market was permanently damaged by existing consumers investing in new oil, coal or renewables capacity.
In a very gas-dependent economy a sudden rise in gas prices would have the potential to cause significant economic disruption. On the basis of the past behaviour of prices it has a much higher chance of occurring at some stage in the future than a sustained quantity interruption. Such a price shock would potentially damage the competitiveness of the economy. From the point of view of the individual firm there will be some incentive to hedge the short-term exposure to price shocks. However, as the exposure of the firm to price shocks may be much less than the exposure of the economy, too little use may be made of means of insuring against price shocks. This means that security of supply is a regulatory issue. It would be worthwhile paying a limited price to insure against such a risk. Some degree of judgement has to be used by regulatory authorities to determine how much it is worth paying for fuel diversity to avoid the very low probability of severe interruption of fuel and electricity
25 Individual businesses would not have to physically relocate elsewhere. Much
more likely would be a situation where output in the firm declines or ceases in Ireland and the market is met from production by more successful firms elsewhere.
supplies, and to avoid the real possibility of large increases in the prices of particular fuels.
Probably the simplest insurance policy that the Irish economy could take against a price shock would be to invest in shares in gas fields in Norway or possibly Russia (or preferably in companies owning a portfolio of gas fields that supply the European area). An appropriate hedge against oil price shocks could be to invest in the shares of oil companies that own substantial reserves of oil. This would provide a financial hedge against such price shocks.26
However, this instrument would provide no insurance against physical interruption in supply on these islands. It might also be difficult to get a broad enough portfolio of such investments to provide an appropriate hedge. Nonetheless, the issue of insuring the whole economy against oil and gas price shocks should be taken into account when framing the investment strategy for the national pension reserve fund (NPRF).