Gas pipeline network key to outlook for Japan's energy mix, N.E. Asian gas grid

Demand for liquefied natural gas in Japan, represented here by an LNG carrier offloading cargo at Tokyo Electric Power Co.'s Futtsu power plant in Chiba Prefecture, could mushroom in response to Kyoto Treaty commitments and an expanded natural gas pipeline system in that country. Photo courtesy of Tokyo Electric.

Gas Demand Structure [39,983 bytes]
Outlook for LNG demands in Japan, South Korea, and Taiwan [37,881 bytes]
Japan's Future Gas Grid [128,881 bytes]
Estimated fuel consumption by gas-fired IPPs in Japan [44,463 bytes]
Successful natural-gas-fired IPPs [62,386 bytes]

Prices of typical gas utilities [86,538 bytes]

The outlook for Japan's energy supply/demand balance and the shaping of government and company policies that will drive that outlook are at a turning point.

While officials continue to grapple with questions over the future shape of Japan's energy mix, they now must conduct this exercise against a backdrop of the Kyoto climate change treaty and a deepening economic crisis in the country.

How this scenario will evolve is crucial not only for the future of Japan's energy equation but also for the prospects for a Northeast Asian gas grid (OGJ, July 6, 1998, p. 27).

The crux of the matter is that Japan, while one of the biggest natural gas consuming nations, has a gas supply network still in embryonic form. For a Northeast Asian gas grid to be fully realized, Japan must undertake a massive commitment to establishing a domestic gas supply network beyond the string of liquefied natural gas terminals dedicated to electric power plants.

How it gets to that point-or even if it chooses to do so-is the most pressing energy question facing the world's second biggest economy.

Official view

A draft report ("Changing Japanese Energy Policy and Its Effects on Natural Gas Demand") prepared this spring for Japan's Ministry of International Trade and Industry (MITI) by the Institute of Energy Economics, Japan (IEEJ)-to which OGJ was given access-underscores the country's energy dilemma:

"Today, Japan's energy supply and demand energy policy measures have come to a turning point. With respect to energy demand, the rate of increase in demand as a whole is projected to remain at a lower level under the current economic climate in Japan. We expect that the high economic growth registered in earlier years cannot be expected to take place again, given the curtailment of public investment dictated by the government's fiscal reform program as it grapples with the protracted economic recession as well as a decline in population.

"With respect to energy policy measures, the main current of deregulation on the one hand and the sharp reduction in greenhouse gas emissions dictated by the (Kyoto) COP3 (the Third Convention of Parties of the United Nations Framework on Climate Change) summit on the other contradict each other, making the prospect for the ultimate solution of the problem still far from certain.

"Although an advisory body will present a report to the MITI minister in the summer, hopefully mapping out the future course of Japan's energy policy, it remains to be seen whether such truly consistent policy measures can be worked out. Under such circumstances, it would be unavoidable for Japan's demand for natural gas in the future to undergo wild fluctuations, depending on the policy measures taken."

Changes in policy

Japan's energy policy has undergone a fundamental revision in recent years.

Whereas in the past, MITI had stressed the importance of a stable energy supply, in the last few years, top priority has been given to a reduction in supply costs through the introduction of competition through deregulation. In the city gas industry, deregulation measures were taken up in 1995 and 1996 that allowed a gas utility to sell gas beyond its service area and that promoted third-party access.

In the electric utility industry, the revision of the Electric Utilities Industry Law in 1995 introduced competition to the industry by allowing, among other things, power utilities to purchase electricity on the wholesale market.

To date, more than 6 million kw of power capacity has been bid successfully by independent power producers (IPPs), with the winning price far below the ceiling (avoided cost) indicated by electric utilities. Along with this, the electric utilities have continued efforts to reduce costs, resulting in a significant decrease in the cost of electric power-although some of this has been offset by the yen's depreciation against the U.S. dollar, which tends to increase the country's fuel import costs.

In an interim report submitted to the MITI minister at yearend 1997, the specially established Basic Policy Measures Committee recommended that all new thermal power plant projects, including large power plants that may be constructed by utilities, be put out for bid.

Deregulation measures taken with regard to the city gas industry-the revision of the Gas Industry Utility Law-preceded those for the electric utility industry, and, on paper at least, sound rather more radical.

A major reason for the need to apply an apparently more radical deregulation of the city gas industry is the wide gap that exists in gas prices between the three or four major gas companies and the remaining 200-plus small and medium-sized gas companies. The average price charged by the country's largest gas utility, Tokyo Gas Co., for example, is less than half of that charged by Tomakomai Gas Co., the country's second smallest city gas company: ¥90.7/cu m, as opposed to ¥90.7/cu m.

The deregulation measures for city gas are characterized by three key points:

Freedom for general gas utilities to supply large customers (defined as those with an annual contracted supply volume of at least 2 million cu m) outside their service areas.
Third party access, in which non-gas utilities can supply large volumes of gas, as long as it causes no damage to general gas utilities.
Ability of gas suppliers and large users to negotiate gas prices directly.

Significantly, these measures include the liberalization of retail businesses, which is not allowed, in principle, in the electric utility industry.

Nevertheless, the effects to date of city gas deregulation have been much less extreme on that industry than have the effects of deregulation on the power industry. Although major gas companies' supply of gas outside their service areas and the wholesale supply of gas by non-gas companies have occurred, their scale has been very limited. Reasons cited for this difference between the electric utility and city gas industries include: city gas companies operating businesses in different forms; a very limited gas pipeline network infrastructure; and the fact that BTU values of gas have not been unified yet.

"Under such circumstances, a rapid change in the gas market is unlikely to take place, even when supply of gas to new areas is expanded and the fee for using other companies' existing gas supply systems is made transparent" IEEJ said.

Kyoto, economic concerns

Further complicating these developments is COP3, held in Kyoto last December. There, Japan made a commitment to reduce greenhouse gas emissions by 6% from 1990 levels.

This has caused great confusion among Japan's energy policymakers, as there is little consistency between efforts to deregulate the energy industry by introducing competition in an attempt to drive down costs and efforts to strengthen regulatory measures to restrict greenhouse emissions: "As a result, public utilities are naturally taking a suspicious attitude towards government policy measures. It is feared that such an unfortunate situation will prevail for some time to come, ruling out any possibility of having bright prospects for the near future," the IEEJ report concluded.

It goes on to argue that energy demand in Japan is very unlikely to grow as rapidly as in the past because of the current recession, long-term population decline, and the slow economic growth accompanying financial reconstruction: "The figure of LNG imports that was forecast by IEEJ in 1995 will be reduced. The demand for electricity and gas may increase a little as a result of deregulation, but it will only be within a range of expectation."

LNG outlook

Concerning the availability of natural gas, Japan's current long-term contracts for LNG total 54.51 million metric tons/year.

There are a great number of proposed LNG export projects for Japan to choose from in the future, and current supplier Qatar, for one, has abundant additional potential capacity to expand LNG deliveries to Japan. Unless a dramatic change from current electricity demand trends occurs, it does not appear Japan will have any trouble being able to secure supplies to meet demand projected at about 65 million tons in 2015.

If, however, the level of natural gas-fired electric power baseload that is being discussed by the government is realized in order to fulfill the Japanese government's commitment to COP3, it is estimated that demand for natural gas, in LNG terms, could jump by a further 20 million tons by 2015. There are enough proposed projects to cover these goals, but the problem is one of cost.

In the case of IPPs, for example, fuel sources of projects awarded in 1996 and 1997 were predominantly coal and residual oil. Indeed, only five cases of natural gas as a power source were included, supplying just 842,000 kw in all, or 14% of the total.

The main reason for this small share of natural gas-fired IPPs was that the winning prices were much lower for steel plants, which have large tracts of idle land available for building power plants, and oil refining companies, which have large quantities of cheap resid available for firing their plants. It is difficult, on the other hand, for gas-fired IPPs to be competitive even for middle and peak-demand zones because of the high cost of city gas.

On the other hand, Japan is under increasing pressure to increase its use of LNG as a means of reducing its CO₂ emissions, which would sharply boost the demand for natural gas from the electricity industry in particular. IEEJ estimates that, if the government were to pursue a policy similar to that in place prior to the Kyoto summit (the so-called "business as usual" scenario), natural gas demand in 2010 would stand at 61.8 million tons, rising to 62.6 million tons in 2015. If, however, the government were to reduce CO₂ emission levels to 1990 levels, IEEJ estimates that demand for natural gas in 2010 and 2015 would shoot up to 73.9 million tons and 80.7 million tons, respectively.

However, it also points out that, for such as scenario to come about, there will have to be a radical-and very expensive-overhaul of the power sector. This, it believes, is unlikely to take place.

"At present, deregulation is being talked about in tandem with policies to bring Japan's energy policy in line with its COP3 commitments. While it is not clear who will bear the expenses likely to be imposed by these commitments, it is not considered that electric utilities will actively expand their use of LNG. This means that there is unlikely to be a big increase in demand for LNG, given that utilities are by far the biggest consumers of natural gas," IEEJ said.

Deregulation measures needed

IEEJ further argues that, for gas utility deregulation measures to significantly affect increased demand for natural gas, a number of additional measures must be taken.

These include the promotion of wholesale gas supply to reduce the gas cost for small and medium-sized city gas companies and the development of a system of gas trunk pipelines to enable direct and economical supply to large users. Although neither of these conditions is directly related to the deregulation measures in the gas utility industry, both are necessary for supplying gas economically to large users in areas remote from the present service areas covered by major gas companies. In the case of small and medium-sized city gas companies, access to large-scale supply capacity of natural gas is a key to ensuring competitive prices.

Another key to promoting the wholesale supply of natural gas is unification of BTU values. In other words, gas utility deregulation measures should promote wholesale natural gas supply, which, in turn, will accelerate this unification. LNG's share, in BTU terms, in the city gas supply mix in 1996 was 77%, while the share of LNG and indigenous natural gas sources together totaled 82%. If the wholesale supply is allowed to expand, the share of natural gas in the city gas mix can be expected to grow to about 92%, estimates IEEJ.

There were 244 gas companies operating in Japan at the end of 1996, of which 39 used LNG and natural gas as their main fuels. Since most of the remaining companies use liquid petroleum gas as their main fuel, a shift by them to LNG would increase demand for natural gas. However, IEEJ also points out that the increase will never amount to much, because the 39 companies already using some form of natural gas account for 87% of total city gas sales in Japan. At most, it estimates, a maximum of 1.74 million tons/year, in LNG terms, can be shifted.

Gas pipeline system

Nevertheless, Japan is now looking seriously at the possibility of constructing a national natural gas pipeline system in an attempt to wean itself of its dependence on nuclear and other fossil fuels with higher CO ₂ emissions.

Giving impetus to this drive are Japan's involvement in the Sakhalin 1 and 2 exploration and development projects and the increasing likelihood that similar natural gas E&D projects throughout eastern Asia could realistically lead to the possible construction of an entirely new and comprehensive pipeline network linking suppliers and consumers throughout the region.

As one senior MITI official told OGJ, "All these factors have made us have a serious rethink about the future direction of the country's energy procurement policy and are making a shift away from oil, coal, and nuclear power and towards increased use of LNG a realistic and attractive alternative."

The irony is that Japan is already the world's seventh largest natural gas user. In 1997, the country consumed about 62 billion cu m (2.2 tcf) of gas, amounting to 12% of total primary energy and consisting mostly of LNG imported for electricity generation. LNG fuels more than 25% of Japan's electric power generation, while nine power companies consumed just over 50% of total gas supply.

However, the manufacturing, commercial, and residential uses of natural gas are very low in comparison with other high-income countries, both on a per-capita basis and as a share of total energy.

Only about 5% of Japan's urban area is served by a gas distribution system. Even the three largest city gas utilities-Tokyo Gas, Osaka Gas, and Nagoya Gas-have distribution mains limited to 50 km from the nearest LNG terminal or synthetic gas plant. The outlying service areas of the big city utilities and the roughly 200 much smaller city gas companies depend on truckload shipments of LNG or, even more frequently, LPG in bottles-"a very expensive way of delivering gas," pointed out Paul Smith, utilities analyst at HSBC James Capel in Tokyo.

"Moreover, landed costs of LNG are then inflated by an inefficient and monopolistic distribution system," Smith said. "The result is that LNG prices for Japanese end-users are three to five times higher than those in the U.S. or the U.K., and more than twice those of other import-dependent countries, such as Germany or France"

Only the electric utilities benefit from this arrangement, given that gas-fired power stations are usually sited alongside marine terminals and are able to purchase LNG in long-term, bulk contracts on the world market rather than from a local gas company.

But for all the country's ambitious plans to import gas by pipeline from Sakhalin or the Asian mainland, it still faces a fundamental problem-there exist neither the pipelines to bring the gas to Japan in the first place nor the pipelines to distribute it around the country once it has arrived: "This is a key reason for Japan's very high retail energy prices, which are a serious burden to the competitiveness of its industry," said Hikaru Yamada, CEO of Sprint Capital Japan and a driving force behind efforts to establish a gas pipeline network in the country. "If Japan is to maintain its status as an economic superpower, this is a problem that has to be solved."

Pipeline initiative

Yamada was instrumental in the establishment of the Japan National Pipeline Research Society, whose 44 corporate members include Japan's biggest gas and electric companies, such as Tokyo Gas, Tokyo Electric Power Co., and Osaka Gas, as well as highly energy-dependent companies, such as Nippon Steel, along with a number of government agencies.

This group argues that the lack of a national trunk line network is a key block to the further expansion of natural gas use in Japan.

"Japan needs to increase its gas use for its long-term energy security, to lower the country's CO₂ emissions, and to mitigate its high energy prices, which are already the highest of the world's top industrial nations," Yamada said.

It was originally assumed that the internal pipeline system would be organized and financed by the central government as a public works project and would operate exclusively to carry gas for the regional gas and electric monopolies. It would basically consist of three discrete components (see map, p. 25):

A 2,500-km Pacific coastal marketing-distribution trunkline, linking the biggest urban centers.
A 2,500-km import trunkline, extending from a subsea intake site for Sakhalin gas at the northern tip of Hokkaido and then along the Sea of Japan coast to the intake point of a proposed Trans-Asian pipeline near the strait that separates Honshu and Kyushu.
Several 200-300 km lateral support lines crossing Hokkaido, Honshu, and Kyushu to link the two trunk lines and provide supply to inland markets.

However, the current poor state of the Japanese economy, combined with bureaucratic hurdles, has since forced those pushing the gas pipeline scheme to look to the private sector, most notably regarding the Tokaido natural gas trunkline system, which would extend 500 km from the outskirts of Tokyo to Kobe.

"The fact that (the Tokaido project) services an area that covers almost 80% of Japan's total energy consumption means that we should not have any difficulty finding investors for the scheme," Yamada said. In an even more dramatic departure from Japanese precedent, the pipeline society has also approached North American gas pipelines, gas and electric utilities, and multinational oil companies as potential active participants in up to about one third of the total investment.

The transmission system would be operated as a non-discriminatory, open-access carrier and would target as direct customers industrial gas users and prospective non-utility electric generators.

Not that getting the project off the ground will be easy: on the one hand there is the sheer size of the investment involved-about ¥300 billion ($2.5 billion) for the Tokaido pipeline alone. "Moreover, this figure pales into insignificance if you start talking about a pipeline link to Sakhalin, or anywhere else in Northeast Asia," Smith pointed out.

"At the same time, international trunk line transportation of natural gas depends on competitiveness in cost, and in order to make best use of trunkline imports, domestic trunk lines must be well-arranged," IEEJ said in a recent report. "However, a large increase in demand for natural gas cannot be expected with the existing routes, meaning that construction costs will have to be shared by existing consumers. Moreover, even if the cost competitiveness of international trunk routes is not bad, their introduction will not be easy until around 2015, because of tight scheduling."

Smith adds that, while it is feasible that the Tokaido pipeline could be largely privately funded, the chances of private institutional investors funding a Sakhalin link are virtually nil, given both the costs and the limited domestic and industrial demand for LNG in the northern half of the country. At the same time, while Sakhalin 2 is due to start oil production sometime next year, natural gas production is still several years down the line.

Yamada admits as much: "This stretch of the network would definitely have to be government-funded." However, he points out that MITI would have much to gain by promoting this project: "It would both complement the Sakhalin development project and allow it to replace plans to build more nuclear plants in northern Honshu with (plans for) LNG-fired ones as well as (plans to) convert existing coal or oil-fired plants in the region to LNG."

MITI support needed

Herein lies another fundamental difficulty: the overcoming of powerful interests.

If the gas network system does become a reality, a lot of businesses, especially those in the transportation sector, such as shipping companies and local gas distributors will be hard-hit. It is therefore vital that the project gets its full backing from MITI in particular. "We are lucky in that an initial indifference to the project by MITI has changed in the light of recent environmental concerns to a much more positive stance," Yamada said.

As a senior MITI official put it, "We might be the 'mother' of the electric utilities, but that does not mean that we are not prepared to push for a reevaluation of the country's energy policy if we think it will be of benefit-even if it does mean hardship to the power companies in the short term. In the long term, they have as much to gain as everybody else."

Yamada confirms this view: "We are not talking about monopolizing the gas distribution system; we are simply trying to provide users with a hopefully cheaper and more convenient alternative. If they continue shipping LNG in and distributing it using existing channels, then we are clearly failing in our task as competitive rivals-and will consequently be the losers."

"Certainly," said Smith, "the move should allow the gas industry to consolidate and reap large efficiency gains. At the moment, there are well over 200 small gas companies with few economies of scale. The result is grossly overinflated prices for consumers."

At the same time, the involvement of a number of U.S. companies in the project should bring wide-ranging benefits in terms of management , operational know-how, and technical expertise.

OGJ has learned that three major U.S. energy companies are likely to be involved in the Tokaido project, and that at least one of them has expressed a serious interest in buying a number of regional gas distributors to complement its participation in the pipeline project.

"But this is all talk, which is precisely why we have just dissolved the National Pipeline Research Society of Japan," Yamada said. "The time has now come to put words into action."