WAXING AND WANING LNG DEMAND IN JAPAN S DEREGULATING ELECTRICITY MARKET A SUPPLIERS PERSPECTIVE.

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1 WAXING AND WANING LNG DEMAND IN JAPAN S DEREGULATING ELECTRICITY MARKET A SUPPLIERS PERSPECTIVE. Smith, S., North West Shelf Liaison Company Miyoshi, M., North West Shelf Liaison Organisation 1. INTRODUCTION For the past 3 years LNG has been an integral fuel source in satisfying Japan s growing energy requirements. LNG has proven a safe, secure, reliable and clean source of energy, originally introduced to increase security of supply by lowering the level of dependence on Middle Eastern crude imports and also to improve air quality. These attributes are still important today and imports have grown to over 5 million tonnes per annum (Mtpa), predominantly for use in electricity generation but increasingly for industry and reticulated town gas. Although the LNG market has been growing steadily over the past few decades, demand modelling studies suggest that the outlook for incremental LNG demand from Japan over the shortterm, especially from Japan s power utilities is in fact weak. This paper aims to explore the reasons that lead to this conclusion and to assess whether there is a brighter future ahead for LNG demand. 2. ECONOMIC DRIVERS AND THERE IMPACT ON ENERGY DEMAND Over the past decade, economic growth in Japan has been a little erratic (see Figure 1). The economy has swung from periods of growth to periods of contraction, primarily as a result of the continuing fallout from the global economic downturn in the latter half of the 199 s and the slower than expected economic reform that Japan is currently undergoing in line with global market pressures. Charges to primary energy demand growth rates in Japan have followed suit as a result of changes in the local economy. Comparison with other benchmark economies suggests that Japan is not fairing as well as it s manufacturing competitors in the region. However due to the immense size of the Japanese economy, growth in real terms has been significant and although currently around late 199 levels due to some major setbacks, primary energy demand growth has remained predominantly positive. Power generation, which makes up approximately 22% of Japans final energy mix has experienced similar fluctuations in demand. Total demand of the six major LNG consuming electricity power utility companies has contracted from 2 to 22 by.6% and is forecast to grow at only a moderate rate of about 1.5% over the next decade (see Figure 2).

2 15.% Primary Energy Change Per Year Primary Energy % Change 1.% 5.%.% -5.% Korea Taiwan China -1.% USA Japan GDP Change Per Year 15.% 1.% GDP % Change (RT 1995) 5.%.% -5.% Korea Taiwan China USA Japan -1.% Figure 1. Comparison of Japan s recent economic / primary energy growth performance with other economies (Source EDMC and BP). 1 Demand (GWh) NEGATIVE GROWTH Tokyo Electric Tohoku Electric Kyushu Electric Kansai Electric Chugoku Electric Chubu Electric Figure 2. Recent historic and future electricity demand forecasts of Japan s major LNG consuming power utilities.

3 3. DEREGULATORY PRESSURES In response to global pressures Japan has undertaken to reform it s economy through a series of deregulatory measures across several industrial sectors. The Japanese Government has focused strongly on deregulation of both the power and gas industries and Japan s Ministry of Economy, Trade and Industry (METI) is currently implementing a series of reforms that will encourage increased competition in both industry sectors. The deregulatory timetable for the power industry showing recent market reforms and future plans is show in Table 1. Timetable ? 25? 27? Third-party access to customer / deregulatory measure Introduction of Independent Power Producers (IPPs) Customers over 2 kw/annum Third party access to grid Customers over 5 kw/annum Postage Stamp Tariffing Customers over 5 kw/annum Introduction of National power exchange market All customers Market Share (%) 26% 4% 63% 1% Table 1. Timetable of market reform for the power industry. The current forward timetable, although speculative, plans for full third party access for customers by 27. Under the current program there are no plans to separate the vertically integrated power utilities into power generation, wires and distribution, and retailing entities. Considering the recent market imperfections seen in the Californian energy market, a slower approach to disaggregation is probably wise. Deregulatory efforts to date have resulted in a healthy development of third party independent power producers (IPPs) supplying to the regional power utilities under long-term power purchase agreements and have lead to tariff reductions of up to 6% to end-user customers. However, only limited third party supply arrangements have actually been made with large usage customers (currently over 2 kw/annum). The reason for this lies mainly with the major power utilities who in response to increasing competition, have strived to reduce costs and increase efficiencies in their systems and have been able lead the tariff reduction trend to end customers. Deregulation is therefore already having the positive planned impact for end customers and will hopefully stimulate growth for the energy sector. Having said this, deregulation efforts to date have only really encouraged development of independent power producers under fairly rigid purchase agreements. Two changes to the market that may increase third party participation are the introduction of postage stamp tariffing which is currently planned for 24 and of a national power exchange market in 25. Both measures will introduce the transparency in the market place that is essential for the encouragement of purely merchant type power producers. 4. REACTION OF MAJOR ELECTRICTY UTILITIES As highlighted above, Japan s power utilities have been striving to reduce costs prior to full deregulation. In particular, the planned change in market dynamics through the introduction of a national power exchange market which will lead to electricity-on-electricity competition is driving power generation cost reductions. The ability to dispatch electricity on a purely economic merit basis will become increasingly important. To this end the power utilities have been examining cost cutting measures throughout their businesses. For the physical power generation sector this has led the examination of costs of the current merit order and changes in philosophy are being seen for both peak and base-load dispatch. For base-load generation Japanese power utilities have traditionally favoured construction of nuclear facilities which, although very expensive to construct, have lower operating costs than

4 alternatives. These have traditionally been complemented by coal and LNG mid-merit facilities. Differences are being observed in the current construction trend, which shows a rapid short-term increase in the completion of large base-load coal-fired power generation facilities. These will be complemented with continued increase in nuclear facilities aimed at offsetting the carbon emissions impact of these coal fired facilities. Over 1.1 GW of additional planned coal capacity and 17.5 GW of additional nuclear capacity are expected to be completed by 211 under the power utilities 22 published facility plans (see Figure 3). Capacity (MW) Reduction in Peak-load Oil Generation Increase in Base-load Coal Generation Increase in Base-load Nuclear Generation Pump Oil Nuclear LNG Increase in Base-load Coal Generation Major Increase in Base-load Nuclear Generation Retirement Plans??? Natural Hydro Coal 1 Geothermal Figure 3. Forecast changes to the generation base of Japan s major LNG consuming electricity power utilities. The utilities are also reducing the utilisation of old generation plant that is both inefficient and expensive to operate, mainly peak-shaving oil capacity, but also old coal and LNG fired plants. Over 4 GW of generation capacity has been decommissioned / mothballed over the past 5 years (see impact on oil from 2 to 22 in Figure 3). The drive appears to be a desire to reduce the amount of over all capacity which stands idle for most of the year but which still requires maintenance and fuel stocks. Reduction in this power generation capacity will be supplemented by increased utilisation of existing and future facilities, but it is worth noting that this approach reduces the overall reserve capacity available in the event of an emergency or sudden increased demand. For the sake of efficiency, utilities are striving to operate closer to their reserve margins. Cost of capital has also come under greater scrutiny. In the past, capital intensive projects have been undertaken with the firm knowledge that expenses could be recouped over several years in a stable environment. Now a greater focus lies on pay-back period which is driving utilities to slow down their capital commitment until absolutely necessary. Third party power purchasing has increased as a replacement for some of the original capital projects planned by the major utilities. Although ultimately improving the long-term efficiency of the system some of the directions outlined above may potentially have a detrimental impact on the overall reliability and security of the power supply system. 5. LNG S ROLE IN THE FUTURE POWER GENERATION ENERGY MIX It is not surprising that an overall reduced primary energy demand has resulted in lower incremental demand for LNG. However, for the power utilities in particular, incremental LNG demand has been further weakened through the compounding of other factors related to general changes in modus operandi in preparation for increasing deregulation. In an attempt to quantify the impacts of such changes the authors have engaged in simple modelling studies of the Japanese power industry using publicly available data and based on economic dispatch principles. The observations from this modelling work combined with market background are discussed below. LNG has traditionally filled a role as a mid-merit fuel. One technological advantage is that gasturbine fired generation capacity can be highly responsive to changes in system load and can

5 therefore be used to match daily demand requirements quickly and efficiently. With short lead construction times gas-fired generation capacity can also be commissioned to match medium term growth patterns. With the partial phasing out of oil as a peaking fuel there appears to be an increasing role for LNG in a deregulated market. However, the impact of weak electricity demand growth combined with the introduction of new base-load coal and nuclear generation capacity (which were originally constructed on long lead to meet emerging energy demand that, due to current difficult economic conditions, has not yet materialised), has resulted in over-supply of base-load power generation facilities. Modelling studies suggest that, in the near-term, these base-load facilities will (if purely economic rational dispatch policies are followed) displace some of the requirement for midmerit LNG, resulting in a sharp contraction in overall demand for LNG from the power industry over the next five years. The reduction is expected to peak at up to 7 Mtpa below 2 levels in 25 and demand is expected to be suppressed for a further five years due to completion of longer lead nuclear facilities (see Figure 4). The impact of this contraction is expected to be more than offset by health growth from the gas industry and increasing demand for third party fired gas power generation Demand LNG Volume (Mtpa) Contracted Supply Figure 4. LNG contracted supply and demand of the six major LNG consuming power utilities over the next decade. An examination of the overall generation mix out to 215 highlights the rapid increase in coal fired generation in the short-term and longer term increase in nuclear generation. LNG remains fairly stable and oil-fired generation is significantly reduced (see Figure 5). The current reduction in LNG demand is expected to be a short-lived phenomenon. In the longer-term, LNG demand for power generation is expected to grow as a result of narrowing costs between power generation derived from different fuel sources. The experience in other markets has been that the high capital costs of coal plants are better appreciated in a competitive, deregulated market than in a traditional, vertically integrated utility market, where capital costs are hidden. Newly announced moves by METI to introduce a coal import tax combined with potential emissions taxation and ash disposal issues will disadvantageously impact coal generation costs, but at current proposed levels the increased expenses proposed for coal fired power generation are not significant enough to alter the economic dispatch order at base-load utilisation rates. Recent incidents involving the nuclear industry and potential pass through of costs associated with spent fuel disposal are expected to increase maintenance costs and reduce over all utilisation rates for nuclear power generation.

6 1 Generation Output (GWh) IPP/Purchases LNG Oil Inter Utility Exchange Coal Nuclear 1 Pump Hydro Figure 5. Generation of electricity by fuel for the six major LNG consuming power utilities. In addition to cost drivers, the operational advantages of gas fired generation capacity in it s ability to rapidly match system load, makes gas fired power generation ideal for new independent power projects (IPPs) and merchant power plants (MPPs), in a deregulated market. In this environment, rapidly changing supply dynamics make the ability to respond quickly to changing electricity pool demand essential for electricity-on-electricity competition. Increased LNG fired generation capacity is also expected to be developed by the regional power utilities in the longer-term through conversion of existing oil generation infrastructure to gas and new build facilities. Additional factors that may positively influence short-term LNG demand from Japan s power utilities include; short-term economic improvements, delays in Japan's base-load coal and nuclear programs and environmental drivers. These influences may be significant. Adaptability and environmental drivers suggest that LNG s future as a major fuel source to the power industry is secure. However, the increasing use of LNG as a peak-shaving fuel fundamental changes future growth patterns. Although expected to increase over-all, LNG demand will become more cyclic, waxing and waning in response to marginal influences such as, introduction of new baseload facilities impacting LNG s mid-merit role; and economic, seasonal and cultural fluctuations effecting LNG s peaking role. NWS LNG modelling studies suggest that on a customer-by-customer basis, regional effects could be quite pronounced, leading to sharp contractions followed by rapid increases in demand. Volume management of such events to date, have been handled through consortium style LNG procurement which has allowed intra-consortium management through processes such as assignment between members. As deregulation bites increased competition has encouraged companies to procure as individuals so that terms and conditions can be tailored to suit. Although contractual arrangements are in place to cope with fluctuating demand situations of individual companies through the provision of upward and downward volume tolerance, increased competition reduces the willingness for consortium type cooperation and places a more direct burden on suppliers who have to maintain sufficient flexibility to cope with this uncertainty. 6. IMPACT ON SUPPLIERS In a capital-intensive industry with less certain market dynamics, who will supply the contracts of the future and will all producers, old and new, survive such waxing and waning LNG demand? The authors of this paper identify three main characteristics that will be critical for supply projects to adopt if they are to succeed in managing future LNG demand uncertainty from their power industry customers: Relationships - suppliers and customers will have to work together in future to manage demand uncertainty through closer communication and different contractual arrangements that provide mutual benefit.

7 Portfolio development as customers seek to increase flexibility to match demand uncertainty clearly suppliers with a diverse customer base (mostly established brown-fields) stand to weather downturns better. Green-field projects, dependent on one or two customers will be potentially over-exposed and can expect contractual flexibility options to be used. Flexibility obviously has a finite cost associated with it and for producers these costs may be a very heavy burden. Security and reliability of supply insufficient supply of LNG could force customers to burn fuels out of merit order or miss opportunities to dispatch into a deregulated power pool. Both have the potential to seriously impact a customers bottom line. In periods of increased demand, customers with sufficient upward flexibility provisions who have procured from reliable suppliers will have the ability to match electricity demand and increase returns. Although some upward flex may be gained from the spot market, in periods of intense demand insufficient supply will be available which could ultimately lead to black-outs as in the case of the California market. Those buyers who have in place sufficient term contracts will be advantaged under these situations. The authors believe that the supply projects who have the ability to develop these characteristics will become the favoured LNG suppliers to power utilities in the future. 7. CONCLUSIONS It is clear that LNG is becoming a far more complex business today as customer s needs evolve with market deregulation. LNG suppliers who have the ability to evolve with their customers will develop the ability to grow in the future. The next few years may well be challenging for the industry but a bright future is ahead!