QUANTITY RISKS 3

The Key Risks

• the operational reliability of energy systems;

• risks related to the scarcity and uneven distribution of primary fuels (leading to a concentration of market power). In the first very unlikely case, physical interruption of the gas pipelines supplying Ireland could leave the economy without gas supplies. Another example, which could give rise to a physical inability to supply a key form of energy – electricity – would be a breakdown in a particular type of electricity generator due to a lack of technology diversification. The second type of interruption covers cases such as political instability in the Middle East or in the sources of gas supply, which could also see a physical interruption in supplies.

Firms (and households) investing in the Irish economy should consider the risk of physical interruption of fuel supply. For instance, any physical interruption in supply would leave a gas-fired electricity generating plant stranded, losing significant profits while fuel was unavailable. In a competitive market firms will factor in some of this quantity risk into their investment decisions in so far as they are liable for the costs of an interruption. However, the potential losses of individual firms are only limited to their medium- run fixed costs for the time that fuel is unavailable and so long as these risks are not insurable commercially.

However, for the economy as a whole a physical interruption in supply of fuel and electricity would be extremely serious where substitute energy supplies cannot be found in a reasonable time scale. Electricity is an essential ingredient in modern life and this is reflected in its very inelastic demand.21 _{A very extensive interruption}

of output across the economy would be inevitable from a prolonged interruption of electricity supplies. While probably less important than the social impact, if an unanticipated interruption was sustained for much longer, the loss of industrial output could seriously affect domestic and export markets leading to a long-run loss of national income.

According to Tishler (1993), there are four sources that contribute to the cost of an electricity outage: foregone profits (output), possible reduction in productivity due to the outage, damage to materials, and payments to labour during the outage. Lijsen and Vollaard, 2004, estimate that the cost in the Netherlands of an unexpected outage leading to a loss of load of one MWh would be €3,000, over forty times the cost of generating such electricity. Costs are likely to increase exponentially with the duration and scale of the outage – the damage done by a loss of electricity will be small for a limited outage but could be massive for a total failure. For example, a loss of 20 per cent of electricity capacity due to a gas

21 _{See J. Fitz Gerald, J. Hore and I. Kearney, 2002, “A Model for Forecasting}

Energy Demand and Greenhouse Gas Emissions in Ireland”, ESRI Working Paper No. 146.

outage could be spread through rationing. A regular rotating curtailment of supply could be controlled to leave crucial sectors, such as hospitals, with continuous supply. However, if the loss of capacity were to rise above 20 per cent the costs and related disruption would be increasingly difficult to avoid through rotating cuts. Thus a loss of 80 per cent of electricity capacity due to gas outage would be more than a third worse than the loss of 60 per cent.22 _{While it is clear that such a severe disruption would have a}

very low probability of occurring, the costs, if it did occur, would be very grave. If this potential risk is to be adequately dealt with, the regulatory authorities cannot leave it to market forces alone, but must take independent action to mitigate the probability of such an interruption.

Historically, geopolitical issues related to the concentration of oil reserves have represented a particularly important concern for governments. Compared with the oil market, the natural gas market is much more constrained by transport infrastructure leading to more region-specific market characteristics.23 _{While currently the}

sources of gas on the EU market are quite diverse, with supplies running out from existing suppliers (e.g. the UK, the Netherlands and Ireland), by 2010 the then fully integrated EU market will be dominated by Algeria, Russia (Gazprom) and Norway. This will be an even more concentrated market than the current OPEC cartel. The switch in sources carries with it further implications for the ability of supply to adjust quickly to changing short-term levels of demand (such as the winter demand fluctuations arising from sudden temperature changes), referred to as the swing capability of the system. The main transnational pipelines that will deliver imported gas are anticipated to have a much lower swing capability than domestic production in these islands. In the European markets, lack of flexibility in contracts and delivery is countered by some gas storage availability in the UK and elsewhere (Oxera, 2004).

While the development of gas storage in Ireland would seem desirable, much would depend on its cost. The geology of the Republic of Ireland is much less favourable than that of Britain or of many other EU countries. However, there are large salt caverns near Kilroot outside Belfast, which could provide suitable storage for significant quantities of gas. With the completion of the North- South gas pipeline in 2007, these caverns could be developed to provide significant gas storage for the island. Such storage could be valuable in smoothing daily and weekly fluctuations in demand and

22 _{It is not feasible to quantify these economic costs in a precise manner as they}

would depend on the extent of the loss of electricity capacity, the length of time power was lost and quantification would require much more economic data than are currently available. See Lijsen and Vollaard, 2004, for a quantification of some of the costs of supply disruption.

23 _{Although the emergence of Liquified Natural Gas as an increasingly important}

means of transport is progressively joining regional gas markets together, pipeline transport remains the predominant natural gas means, limiting the geographic range of international gas trade.

also in providing a buffer against short-term disruption to supply. The possibilities of developing such storage should be examined as part of the development of the all-island energy market.

A relatively low price elasticity of demand for gas in the medium term confers considerable market power on the small number of major suppliers.24 _{This leaves open the possibility that gas prices}

could be dramatically raised for a sustained period through a voluntary restriction of supply. It is this risk of a future price shock lasting months or years that needs to be considered by Irish energy policymakers.

In many cases shocks that are perceived as being quantitative in nature (e.g. a shortage of oil) can readily be turned into price shocks. Price shocks allow for some market response modifying the costs of an interruption. For example, in the late 1970s action by the Irish government in the face of oil price shocks did the reverse – by restricting the price of oil, a price shock was turned into a quantity shock where supplies were not available to meet demand at the going (restricted) price. The resulting disruption magnified the already significant cost to the economy.

Looking out into the next decade, the rapid growth in the world economy, especially in China and India, is likely to put major upward pressure on demand for oil. At the same time discoveries are not taking place at a sufficient rate to keep pace with demand. As a result, it is quite likely that real oil prices will rise rapidly over the next two decades. However, it is most unlikely that the imbalance between demand and supply would lead to any prolonged physical shortage. Rather the market will operate to ensure that oil is available, albeit at an ever-increasing price.