Partner & Associate Director
Growing demand for hydrogen will impact transportation and distribution networks differently. Players must plan ahead if they are to successfully navigate the coming disruption.
The energy transition raises questions for midstream gas players. Most crucially, since clean energy is set to replace fossil fuels in the coming decades, what happens to the regulated pipeline businesses that provide the infrastructure to carry natural gas? Here’s how we see it.
Growing demand for hydrogen and other low-carbon fuels will create opportunities for pipeline operators and owners. But how these play out will vary, depending on the type of network. Companies operating long-distance transportation pipelines that connect supply points with areas of demand could be relatively unaffected by the shift toward cleaner alternatives as their pipelines are repurposed to carry hydrogen.
By contrast, operators of distribution networks that deliver natural gas to homes and smaller businesses could see a significant decline in volumes as a result of electrification and customer efficiency measures. But the level of disruption across their networks will be uneven, with location, customer mix, and the availability of low-carbon fuels all playing important roles.
Looking ahead, the previously safe and predictable midstream gas sector is set to experience significant change. Although the full effects of declining natural gas demand may not be felt for some time, pipeline operators, owners, and regulators need to prepare now. Operators and owners will have to make vital decisions about where to invest for future growth and which parts of their networks to ax. And they will need to work with policymakers and regulators to draft new rules to smooth the transition toward low-carbon fuels.
In recent decades, demand for natural gas has grown faster than for any other fossil fuel, and natural gas now accounts for almost a quarter of the world’s total primary energy demand. Because it is cleaner than other fossil fuels, natural gas has an important role to play as a transitional fuel to a net-zero world. Consequently, overall global demand for the fuel is likely to increase for the next several years. But growth will be increasingly uneven. Natural gas demand in some regions and in some consumer segments will reach a tipping point and start to decline before 2030.
Despite its environmental benefits relative to other fossil fuels, natural gas faces gradual replacement by low-carbon solutions in all major gas segments as energy efficiency and decarbonization initiatives accelerate. In power generation, a combination of renewable energy and batteries will be the dominant technologies supplanting natural gas. In industrial uses, hydrogen and, to a lesser extent, other low-carbon fuels will take over. And in heat generation, decarbonized district heating and electrically powered heat pumps will play a major role in reducing demand for natural gas.
Europe and other regions with a strong commitment to decarbonizing their economies, including Australia and some parts of the US, will lead the way. Most forecasters predict that European gas consumption will peak around 2025, ahead of all other parts of the world. (See Exhibit 1.)
In these three regions, aggressive policy initiatives will affect—or already are affecting—gas consumption:
Natural gas pipeline players in Europe, Australia, and the West Coast of the US face the greatest near-term changes to their networks from falling consumption. Complicating matters, the rate of decline in natural gas consumption will not be the same in all segments. Residential usage will see the biggest impact, as a result of increased home insulation and of government policies that promote replacing natural gas boilers with electrically powered heating systems.
Power generation and industrial companies—especially those that use natural gas for high-grade heat and as chemical feedstock—will take longer to change to alternative fuels. But over time, only companies that can use carbon capture technologies to sequester the CO2 emissions from natural gas combustion, and improve their financial standing by doing so, are likely to continue to be significant natural gas customers.
In power generation, natural gas will remain an important fuel because gas-fired plants can provide flexible backup power when renewable energy sources are down. Demand for natural gas might even rise temporarily as the electrification of transport and heating, combined with the retirement of coal plants, increases the need for gas-fired power plants. But in the long term, the amount of gas-fired power generation must drop if we are to achieve net-zero emissions worldwide by mid-century.
The developments noted above will play out differently for different types of gas networks.
Transportation Networks. In general, although declining natural gas volumes will impact operators of high-pressure transportation pipelines, the energy transition will create opportunities for these companies in two important areas.
First, transportation pipeline operators will play a crucial role in providing the midstream infrastructure for new low-carbon fuels such as hydrogen. In all cases where companies have a choice, they will find it cheaper to retrofit existing pipelines to carry hydrogen than to build new ones. According to the European Hydrogen Backbone, an initiative set up by 23 gas infrastructure companies, repurposing high-pressure pipelines costs one-third of the one-off investment expense, and 30% to 50% of the full-life cost of an entirely new network. (See “Preparing Gas Networks for Hydrogen.”)
Whether they need to build afresh or alter their current networks, existing gas transportation pipeline operators have deep experience and consequently are the clear favorites to build and run hydrogen midstream infrastructure.
Second, remaining natural gas usage will be concentrated primarily among companies that require significant volumes of the fuel, such as power generation and industrial users. These large players can deploy carbon capture technologies to sequester emissions, so some could continue to be natural gas customers over the long term. Most of them will get their natural gas directly from transportation rather than through distribution pipelines.
Distribution Networks. Pipelines that take gas from the transportation network and deliver it at lower pressure to residential areas and smaller businesses via a widespread network are likely to see their volumes decline more steeply. Several key factors underlie this probability. The electrification of heating, energy-efficiency measures and policies aimed at curbing the use of natural gas, and a warmer climate will all contribute to reduced demand. For smaller gas consumers, hydrogen is less likely to be an effective substitute for natural gas. In many instances, district heating or individual electricity-based heating offers better long-term economics. Hydrogen-based heating is preferable only in situations where these other approaches are unfeasible, owing to such factors as lack of space or financial resources. Biomethane may offer another alternative utilization of distribution networks, but its use will be limited to areas that are close to sources of sufficient supply, such as from agriculture. The impact of these developments, however, will vary from one player to the next—and even within networks. (See Exhibit 2.)
As demand for cleaner fuels grows, blending low-carbon fuels with natural gas will be an essential transitional step for transportation and distribution network companies. Blending will also allow them to develop valuable capabilities in handling and accessing future fuels such as hydrogen.
Several countries already allow pipeline operators to carry blends that are up to 6% (by volume) hydrogen—and up to 10% under specific conditions. Industry studies and pilot projects indicate that existing natural gas networks can even accommodate blends containing as much as 20% to 25% hydrogen, with moderate investments on the user and operator sides, before safety, operational, and asset integrity considerations become significant issues. (See “The Challenges of Blending Hydrogen with Natural Gas.”) Studies are also underway to examine the feasibility of deblending technology, which would separate blended hydrogen and natural gas into homogeneous streams once the blended gas arrived at its destination. There is no comparable limit to the percentage of biomethane that can be blended with natural gas. But supply constraints are likely to prevent biomethane from being a viable candidate for high-ratio natural gas blends.
When the proportion of natural gas in blended mixes falls below specific limits, pipelines typically must either be repurposed to become dedicated pipes for hydrogen or other low-carbon gaseous fuels or be shut down entirely. Although repurposing will be a viable option for many network sections, the economics are likely to be challenging for companies that operate pipelines that serve large areas with dispersed populations, since those circumstances make the cost of investment high in comparison with achievable user revenues.
Economic and operational factors can justify decommissioning pipelines before gas usage reaches zero. Funding decisions, the availability and benefits of alternative technologies, and customers’ climate-related behaviors may change from one neighborhood to the next within the same gas network, making different pipeline sections unfeasible at different times and in different locations.
For example, neighborhoods containing a larger proportion of proactive customers or a relatively high share of house refurbishments may switch more rapidly to heat pumps. We estimate that in neighborhoods where political considerations, climate concerns, and customer behaviors enable faster switching from natural gas, as much as 80% of the existing natural gas distribution network—as well as up to two-thirds of future capex spending if companies invest in the wrong areas—could be at risk of becoming stranded assets.
Given the long-term investment horizons that typify the sector, companies in the midstream gas industry need to think several decades ahead. Gas pipelines can last for 50 years or more, which means that companies face the very real possibility of being encumbered with stranded assets if they don’t make the right choices now and leverage new opportunities from the energy transition. Here are some of the steps that different players must consider.
Pipeline Operators. Pipeline operators should focus on three key topics:
Pipeline Business Owners and Investors. The opportunities for expanding into new business areas can differ significantly from one company—and from one network section—to the next, as can the accompanying challenges. Owners and investors in pipeline businesses also face higher risk and investment requirements than in the past. In response to these forces, network companies are adopting a range of responses. Some have moved out of gas distribution, investing instead in electricity. Others have proactively encouraged electrification of areas where natural gas has traditionally dominated. Many companies are experimenting with hydrogen, hydrogen blending, and CO2 technologies. And several players are following a wait-and-see strategy.
We recommend that players keep the energy transition in mind when reviewing their pipeline investments. They should prioritize investments in companies that will benefit from future energy transportation routes (for example, connecting hydrogen supply with demand), that have a robust position in areas with more concentrated customer segments (for example, power or centralized heat generation), and that operate in a supportive regulatory environment (for example, one where regulators have adopted a clear and fair approach to guiding the energy transition and are willing to adjust tariffs to reflect changing volumes, costs, and risks).
Because regulatory periods typically last four to six years in most jurisdictions, a company may not immediately feel the impact of cost and volume challenges. For the same reason, company valuations can be relatively sticky, though all energy companies are under increasing pressure from climate activist shareholders. Nevertheless, business owners and investors should monitor changes in energy usage closely.
Regulators and Policymakers. Regulators will soon face a tough challenge from the changes that the energy transition will bring to midstream pipeline businesses. As operators deal with lower natural gas volumes, higher risk, and increased investment in new or repurposed pipes, customers that continue to use their networks for natural gas could end up paying more. Rising network costs can accelerate the move to alternative fuels: as more and more customers leave the natural gas network, the remaining customers are left with higher bills and so are more likely to exit themselves. (We’ve seen this phenomenon already in the impact of distributed solar power generation on electricity grids.)
Regulators must factor this scenario into their plans to ensure that midstream pipeline companies are properly compensated and remain financially strong in readiness for the energy transition, and to prevent customers from being left behind and exposed to steep price rises if, for example, an alternative technology is not available in their area. To understand the potential impact of regulatory change on demand for both gas and electricity, which are increasingly interlinked, regulators should use more sophisticated modeling and simulation tools. Three topic areas are particularly important:
Midstream players need to act now to plan for a net-zero future, with declining natural gas demand and a widespread switch to hydrogen. Although some of the developments outlined above will happen sooner than others, it would be a mistake for companies to dither and postpone making suitable preparations. The energy transition has shown that global shifts away from fossil fuels can happen unexpectedly quickly. And the midstream gas market is likely to be no exception to this rule.