Canada's 'Energy Insecurity' and Asia

Author: Jeff Kucharski

Canada faces an uncomfortable energy predicament. The Keystone XL pipeline delay, the shale oil and gas revolution, energy price volatility and environmental politics have emerged as watershed issues confronting Canada's energy system. These issues, along with internal constraints and developments beyond Canada's borders, increasingly challenge the country's ability to secure alternative markets for its energy resources and threaten Canada's long-term economic prosperity. Canada needs to deal with these issues in a more comprehensive and coherent way by developing a strategy to preserve and enhance its energy security. And that strategy needs to include Asia.

Energy Security

Energy security is about much more than just how well endowed a country is in energy resources. It encompasses a broad range of issues, including the availability of and accessibility to energy resources and markets, affordability of energy services and the acceptability of energy activities. Preserving and enhancing energy security is fundamentally about managing a wide range of risks and uncertainties that affect the energy system over the short to long term. Until recently, Canada’s abundant resource endowment, high prices for energy commodities and preferred access to the huge US market meant that energy security – which for Canada means “security of demand” – was not an issue that warranted attention.

Yet energy security has been a top-of-mind issue in most countries, especially those that must import energy resources to power their economies. This indeed is the policy mindset for most of the countries in Northeast Asia (China, Japan and South Korea) for whom energy security usually means “security of supply.”

Canada, Asia and the Energy Security Opportunity

Global threats to energy security are increasing, including the use of energy as a political “weapon" by Russia, the militarization of the East and South China Seas and ongoing instability in the Middle East. In the context of these issues, Prime Minister Harper has heard from leaders in China, Japan the EU and elsewhere about their strong interest in Canada being a stable and reliable supplier of energy.

Asia represents by far the greatest long-term opportunity for Canada to reduce its reliance on the US market and should be the centrepiece of any future energy security policy or strategy. For example:

  • China is now the world’s largest energy consumer, importing large volumes of oil, natural gas, liquefied natural gas (LNG) and coal.
  • Japan is by far the largest LNG importer, followed by South Korea and China. [1]
  • Asia is expected to import two out of every three barrels of crude oil by 2040, and, led by China and India, is forecasted to be the largest consumer of natural gas in the world, accounting for 60% of global LNG trade by 2040. [2]

In the medium term, Canada’s opportunity for energy diversification is in meeting Asia’s growing demand for LNG Asia accounts for about 75% of the world LNG demand with Japan and South Korea together accounting for about 50% of that. China, India and Southeast Asia represent about 15.5 %.  Future growth in Asian LNG imports will increasingly be driven by these countries and sub-regions.

With security of supply a top policy concern in Asia, the need to diversify crude oil supplies away from a heavy and increasing reliance on the Middle East means that the largest importers – China, Japan and South Korea ­– will continue to try to expand imports from countries that are seen as stable and reliable partners. This presents a huge opportunity for Canada as long as the required oil export infrastructure can be built.

Prospects for LNG in Japan and South Korea

As countries that must import virtually all their fossil fuel requirements, the governments of Japan and South Korea manage risk by setting quantitative targets for the composition of energy sources used in their economies, known as the “energy mix.” The ideal energy mix depends on balancing several factors: the level of renewables and nuclear power generation, the cost of imports, the impact of electricity prices on domestic competitiveness and diversification of fuel sources. In the case of Japan, the government has stated that nuclear power will need to play a continued but more limited role in Japan’s electricity generation mix, subject to new and more rigorous safety checks and regulations.

While Japan’s latest energy mix targets are expected sometime before June 2015, it is likely that only about 12-15% of Japan’s electricity demand will ultimately be met by nuclear. [3] The approval and restart process for nuclear reactors is likely to roll out slowly over the next several years, so Japan’s imports of LNG are expected to remain relatively unchanged in the medium term and to decline only incrementally as increased renewables generation and energy conservation measures take effect. Meanwhile the Japanese government has set “soft” targets for diversifying LNG imports, with several projects in Canada with Japanese equity participation being counted on to provide as much as 10% of Japan’s LNG import requirements. [4]

The government of South Korea finalized its 2nd Korean National Energy Master Plan in 2014 and set long-term targets for its energy mix. The plan includes reductions to South Korea's reliance on nuclear power to 29% of total power supply by 2035, down from a previous target of 41% by 2030. Nonetheless, overall South Korean power demand will increase with economic growth, and plans to add another 11 nuclear plants by 2024 are proceeding. As a result, while LNG demand may weaken in the short term as new reactors come online, the government forecasts demand for LNG to increase by about 60% by 2035.

Current Trends Impacting the LNG Opportunity in Asia

Price and the evolution of LNG contract terms are likely to be the biggest challenges facing the viability of Canada’s LNG industry. Most LNG is sold on long-term contracts in which the price of LNG is linked to the price of oil. Since most LNG is sold this way, even LNG that is sold on the spot market (i.e., not on a long-term contract) is highly influenced by the price of oil. Consequently, as oil prices have fallen over the last year, so too has the price of LNG. The current low-price environment for LNG and the high cost of building new infrastructure in Canada is putting pressure on proposed LNG projects to demonstrate viability. While many observers in Asia see LNG spot prices remaining around $7/mmbtu (less than half the price of a year ago) for as much as two to three years, some major Canadian LNG project proponents will likely receive higher contract prices that should allow these projects to proceed.

LNG will play an important role in regional trade going forwardWhile Asian markets expect a moderate recovery in LNG prices from current low levels, the need to meet upcoming global climate change targets, limit dependence on nuclear and coal and diversify the electricity generation mix means that LNG will play an important role in regional trade going forward. As the world’s largest LNG importer, Japan’s strategy is to use its position as leverage to promote intra-regional LNG trade. It is currently implementing a three-stage process of electricity market liberalization that will see full competition introduced into generation markets by 2020, and retail gas market liberalization by 2017. Japan hopes not only to make its domestic energy market more competitive, but also to increase the competitiveness of its companies trading LNG in Asian energy markets.

In anticipation of this, Tokyo Electric Power Company (TEPCO) and Chubu Electric announced last November that they would create a new company to combine their gas businesses. The new company will be the world’s largest single LNG customer, with 16% of global demand. Similar partnerships are expected in the future as new players are likely to emerge and existing ones are likely to seek strategic alliances. For example, Japanese and South Korean utilities are beginning to undertake joint purchasing of LNG and together with India have talked about cooperating in a “buyers club” to increase their leverage over pricing negotiations with suppliers.

Asian buyers are keen to alter the long-term LNG contracting system in general. The view in Japan and in much of Asia is that while the recent oil and gas price declines are a welcome development, they do not solve the long-term problems posed by the oil-indexed pricing mechanism used in Asia. These problems include the relatively higher prices Asian countries have had to pay for LNG (the so-called “Asian premium”) and destination clauses in LNG contracts that made it impossible for importers to trade or re-export LNG cargoes. New LNG contracts with North American suppliers are increasingly adopting alternative pricing formulas that are de-linked from oil prices, dropping destination clauses and providing more flexible terms.

However, the market will not be the only arbiter here; the reality is that many Asian governments view energy as a “strategic” commodity that is critical to the sustainability of their economies and are therefore willing to employ non-market strategies to acquire technology, gain market expertise or enhance energy security. Such strategies include the use of “energy diplomacy,” low-interest loans and other incentives to promote the development of overseas energy projects. For example, China’s “going out” strategy empowered its state-owned energy companies to make significant investments in overseas energy projects, including in Canada.

South Korea’s state-owned enterprises have also been active investors overseas and in Canada. The Japanese government promotes “self-developed” fossil fuel supplies from energy projects located in low-risk foreign countries that include equity participation by Japanese companies. Such projects are seen more favourably than imports from independent sources because they are viewed as increasing Japan’s energy independence and energy security.

Implications for Canada’s Energy Trade and Investment with Asia

So what are the implications of these trends for Canada’s energy position in Asia, and what elements should be included in an energy security strategy that makes Asia a key diversification priority?

First and foremost, Canada obviously needs to concentrate on overcoming the barriers to energy infrastructure projects at home. Legitimate environmental, safety and aboriginal concerns need to be addressed with long-term solutions. Canada’s credibility is at risk in Asia in light of the inability to complete necessary export infrastructure that would make good on the political rhetoric about Asia being a priority for Canada. Competitors such as Russia, Central Asia, East Africa and Australia are moving far more quickly and tangibly to meet Asia’s growing energy demand.

Second, Canada’s energy sector needs a shift in mindset toward how it engages with the world outside of the United States. The Canadian energy industry is highly engaged and familiar with Canadian and US markets, political issues and business practices. Yet apart from the major international energy companies, there is little understanding of how Asian energy markets operate. The Canadian Association of Petroleum Producer’s (CAPP) has been almost completely focused on North American issues, but its expertise on offshore markets is not up to the current challenge. Part of the problem is the “produce and ship” mindset held by many of the Canadian independent energy companies who are production-focused and lack downstream knowledge and capabilities, let alone international market expertise.

There are, however, opportunities to partner with Asian organizations and organizations in Canada that have that expertise. CAPP should focus more resources on Asian markets and promote Canadian energy interests in Asia, perhaps in partnership with Asian energy industry associations. At the same time, Canadian industry should explore partnerships, alliances and new ways of developing business relationships that can reduce risks and provide long-term benefits for both sides.

Canada’s energy resources can become a source of competitive strength through the manufacture of refined products for Asia’s growing economiesThird, Canada needs to diversify not only the countries it exports to but also the type of products it exports. With oil and gas prices likely to stabilize at lower levels for the foreseeable future, Canada’s energy resources can become a source of competitive strength through the manufacture of refined products for Asia’s growing economies. Partnering with Asian investors to produce petrochemicals, liquefied petroleum gas (LPG) and other inputs to further-manufactured products may be a good strategy to diversify Canada’s economy while taking advantage of low primary energy costs, existing transportation infrastructure to coastal ports and increased social acceptability of products that may pose lower safety risks and are less environmentally contentious.

Fourth, Canadian governments can play a more proactive role in enhancing international energy relations. Asian governments seek free-trade agreements that provide enhanced access to energy supplies. Over the past decade, the governments of China, Japan and South Korea have concluded FTA/EPA agreements that include specific clauses related to trade and investment in energy, including in the Japan-Australia Economic Partnership Agreement and the United States-Korea and Canada-Korea free trade agreements. In its negotiations, Canada should push for removal of punitive tariffs that some Asian countries impose on petrochemical feedstocks (i.e., what is used to make petrochemicals) that make Canadian refined exports uncompetitive in those markets. At the same time, while the federal government and several provinces have signed energy cooperation framework agreements with some governments in Asia, follow-up that includes specific initiatives with clear goals and measureable targets has been lacking because of Canada’s preoccupation with energy issues at home and its inability to complete required energy export infrastructure in a timely fashion.

Canada continues to hold tremendous advantages for Asian investors, many of which centre on what Daniel Yergin has called “above-ground factors”: political stability, the rule of law, a fair and transparent regulatory regime, liquid capital markets and low corruption. To this list we can add secure sea-lanes and lower shipping costs, both of which are very important considerations in Asia. What Canada lacks is a consistent and determined commitment and a well-conceived strategy to make the region a priority for its future energy security.

Canada: In Need of a Strategy

One of the most important things Canada needs to do is to develop a coherent strategy. Part of the problem for Canada is that it has a fragmented and uncoordinated approach to managing energy issues. Canada is the only nation in the G-7 without an explicit national energy strategy or energy security policy that could comprehensively respond to many of these issues. Most other major energy producing and consuming countries have explicit national energy security policies. Attempts at pan-Canadian energy initiatives have been frustrated because many of the levers of energy policy are in provincial jurisdiction and energy-related needs vary widely across the country, making a national consensus difficult.

The federal government has been reluctant to take a leadership role in forging a strategic approach to energy for fear of suffering political fallout if talks fail and being on the hook for new spending if they succeed. As a result, it has preferred to let the provinces take the lead while focusing on the few areas under federal jurisdiction (such as energy research, energy efficiency programs and international trade) and relying on market mechanisms to resolve short-term energy security issues. Needless to say, the result has been a lack of coherence in national energy policy. [5]

In many respects, the history of the development of the Canadian energy sector has been a major success story. But if Canada is to remain competitive and be seen as a reliable and responsible energy supplier in Asia and other markets, it is going to have to do some things differently. One of those things is how energy issues are dealt with nationally. Developing an energy security strategy for Canada would require unprecedented collaboration among all levels of government, the energy sector, aboriginals and stakeholders. It would help Canada shape its own energy future and avoid being caught without a plan when the unexpected happens – and the unexpected always happens.

Jeff Kucharski is a former Assistant Deputy Minister with the Alberta Department of Energy and until 2012 was responsible for Alberta’s international energy policy, intergovernmental relations and energy strategy. He has lived and worked in Asia several times over the course of his career, including positions with Canada’s Department of Foreign Affairs and International Trade and as Alberta’s chief trade representative in Japan. He is currently at Kyoto University’s Graduate School of Energy Science in Kyoto, Japan.

 

[1] BP Statistical Review of World Energy 2014, BP Global, 2014.

[2] International Energy Agency (IEA), World Energy Outlook 2014 and Institute of Energy Economics, Japan (IEEJ), 2014.

[3] At least two reactors should restart operations in 2015 with a further two to follow possibly later in the year. The Sendai 1and 2 reactors were approved by the Japan Nuclear Regulation Authority in 2014 but require further checks. Approvals are being requested for Takahama and 2 reactors, which means they could restart as early as November 2015.

[4] Based on proposed projects with Japanese equity participation (Aurora LNG, Pacific Northwest LNG, LNG Canada, Triton LNG) and total export commitments to Japan of 8.6 Mt per year. Information based on 2013 import figures, data from the Japan Ministry of Economy, Trade and Industry (METI) and interviews.

[5] A rebuttal to this assertion could be made by pointing out that Canada ranks near the top on international rankings of energy security, even in the absence of an energy security policy. However, the problem with many international indexes is that they are heavily weighted toward indicators of domestic supply security (since most countries are net energy importers) allowing Canada’s vast and diverse energy resources to mask other weaknesses, such as inadequate export infrastructure and lagging performance on GHG emissions. International indexes also fail to adequately account for social acceptability factors and the reliance of countries such as Canada on access to export markets for their energy security.

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