Industrial conversion to natural gas—An efficient and risk neutral strategy?

Abstract

The natural gas industry is very capital intensive. In order to reach high volumes of usage quickly it is extremely important to motivate industrial companies to replace their existing energy sources, mainly fuel oil or gas oil. To accomplish this the natural gas industries in the Nordic countries applies a substitution pricing rule, i.e. prices based on the costs of their industrial customers' existing energy alternative. In this paper the present pricing of natural gas in the Nordic countries is discussed and analysed both from a theoretical and practical perspective. Furthermore, a comparison is made between the decision-making in industrial companies concerning natural gas conversions and the theoretical rules for capital budgeting decisions. Thereby the economic risks connected with such conversions are described and analysed. We find that the present substitution pricing will in the long term be inefficient for the natural gas industry. The prices are disconnected from its cost structure. This will lead to capacity problems during peak demand periods, since natural gas consumers get the wrong price incentives of how and when to use the gas. In many industrial companies the substitution pricing seems to be regarded as favourable. Managers are anxious for a cost neutral substitution to the new energy source. Therefore they have been rather satisfied with unchanged energy costs when converting to natural gas. However, this seems to be a short-sighted perspective. Natural gas and oil have different risk characteristics. The distribution systems, for instance, are vulnerable in very different ways and perhaps even more important, the world natural gas reserves are much larger than those of oil. From a strategic perspective, it seems unwise by the industrial companies to accept natural gas prices that are related to the development of oil market prices. The acceptance means that a new strategic investment regarding their future energy use will be dependent on the conditions for an investment decision that was made long ago.