European governments introduced gas market areas with entry-exit tariffs because of the perceived benefits for opening the European gas market to competition. In practice, gas market areas abstract from the underlying physical realities of the network and do not signal the locational value of gas, which introduces a competitive distortion. From a theoretical standpoint, market areas promoting competition are an economic distortion.

NERA Director George Anstey and Associate Director Marco Schönborn examine the welfare effects of expanding gas market areas and the circumstances in which a larger gas market area increases or reduces economic welfare. The authors look to neoclassical economic theory, which tells us that a market area by itself is a distortion compared with point-to-point tariffs. Hence, market areas—let alone mergers of these areas to make them bigger—are economically inefficient.

Yet market areas were promoted by policy makers and regulatory authorities throughout Europe and even became the compulsory form of organising gas markets following the Third Energy Package of 2009. The original purpose of entry-exit zones was to increase competition and liquidity of wholesale markets. Market areas and their mergers were arguably a pragmatic response to (perceived or real) problems. As a result, it is questionable how much mature gas market areas may still benefit from an increase in competition and liquidity, raising the question if further market distortions through an expansion of market areas can be justified. However, the authors also find that decarbonisation and stranding risks in the gas sector may actually create new incentives for market mergers—if only tariff setting regulation could be amended. It is therefore an apposite time to question if it is useful to continue expanding or merging market areas.

In their conclusion, the authors observe that fundamental economics, as applied to gas market areas, also largely applies to the future make-up of hydrogen markets. In that sector, much remains to be decided, but the authors expect European policy makers will likely follow a similar approach as in the gas market. It might be advisable to pause for thought and ponder the questions the authors have raised before going down the well-trodden path of the gas sector.

The paper has been published in the Journal of Energy Markets; click here to access.