The natural gas sector in Italy ? as broadly described in the recent sector study published by MCC's Industry Research Department1 ? is characterized by high growth rates and the rapid development of both a regulatory framework and corporate activity. The drivers behind expectations of a significant increase in investment and an acceleration of the industrial and corporate restructuring processes are forecasts of a growth in consumption rates and the effects of the gradual liberalization of the energy market.

The implementation of European Directive 98/30/CE is beginning to produce initial results in terms of opening up a protected market, which traditionally featured vertically integrated public monopolies. This new context favours significant investment policies for both gas operators seeking to expand their business, as well as utilities and oil companies eager to reap the opportunities resulting from growth in the sector.

Estimates of the evolution of natural gas consumption demonstrate that the European market is headed for rapid and significant growth over the period from 2000 to 2010. Compared to a consumption level of 413 Bcm (billion cubic metres) in 2000, a consumption of between 503 Bcm and 523 Bcm is foreseen for 2010, with an annual growth rate of between 2.0% and 2.4%.

Italy, which today is rated in third place for consumption, will contribute between 17.4% and 19.0% of overall growth in demand for natural gas in Europe over the 2000-2010 period. This increase in consumption will be led by a considerable increase in demand from the thermoelectric sector, which is notably higher than the European average (an average annual growth rate of 5.9% ? 6.3% during 2000-2010 period), deriving from the re-powering program of the thermoelectric plants and by an increase in demand from IPPs.

In evaluating this growth expectation it is necessary to consider the extremely high level of dependence by EU countries on foreign sources (47% in 2001). Alongside forecasts of an increase in consumption levels, supply from non-European sources is also expected to grow significantly, reaching a proportion of approximately 57% in 2010. This will, however, require considerable expansion of the European countries' importation infrastructure.

Italy's dependence on foreign sources is estimated to reach 86% in 2010, compared to 78% in 2001. The expected increase in demand is already reflected in the supply strategies of the main Italian operators; in the last few years Eni, Edison, Enel and other supply consortia (e.g. Plurigas) concluded new long-term supply contracts. To increase the capacity for receiving natural gas there are several important projects underway for new LNG Terminals (Adriatic off-shore, Brindisi, Taranto) and the development of new import pipelines (a undersea pipeline from Libya and the enlargement of the TAG network).

The liberalization of the Italian gas sector, commenced with the Legislative Decree 164/00 (the ?Letta Decree?), which implemented Directive 98/30/CE. This has established a higher degree of opening of the market than that foreseen on average by the EU countries. The innovative elements introduced merit the attention provided to this market by domestic and foreign operators.

The risk profile of the gas companies tends to change. Each of the phases of the gas value chain can be considered a distinct business characterized by optimal minimum size, by different competitive modalities and by different technological profiles, i.e., by a specific risk/return profile. The risk, therefore, varies according to the industrial strategies adopted in terms of strengthening of any specific activity segment and the policies pursued with regard to vertical and horizontal diversification.

The traditional organization of the natural gas market, characterized by the presence of a limited number of vertically integrated incumbent operators, and the minimal progress so far made toward of unbundling the various phases of activity, do not allow for a clear identification of margins and efficiency standards associated with the different segments of the natural gas sector value chain. Looking ahead in the context of the elimination of cross subsidies, the level of competition that will be established in the single phases of the gas value chain and the consequent pressure on profitability margins will be determined by the unique characteristics of the different business segments and the regulatory framework that will emerge:

? upstream activities: notwithstanding a marked transformation aimed at promoting the competitive confrontation of operators, these activities are expected to be performed by a limited number of companies, in the medium- to long-term. The absence of gas-to-gas competition and the prevalence of TOP contracts bring about a rigidity that is unlikely to be eliminated. These factors contribute to consolidating the positions of the incumbent operators, which will maintain a high degree of control on margins;

? transport and distribution activities: these emerge as natural monopolies, subject to regulatory standards displaying different characteristics in each EU country. Competition among operators in this segment of the gas chain is limited to distribution and competition remains limited to winning of tenders;

? sales activity: the only segment of the gas value chain that is capable of offering a significant level of competition, due to its non-capital intensive nature and the low entry barriers for new operators. Nevertheless, the different degree of market opening to end-users in each EU country carries the risk of slowing down the formation of a single competitive market. Moreover, customer switching remains unlikely if not accompanied by a significant reduction in prices for end-users Brand recognition, therefore, assumes a decisive role, favoring those operators with a consolidated market position who are also capable of distributing the costs associated with the marketing of its brand to a large customer base.

Subsequent to the opening of the Italian market on January 1st 2003, companies active in the distribution and sales segments are implementing strategic alliances to consolidate their presence in the market. This solution allows companies to strengthen their bargaining power vis-a-vis suppliers and carry out joint management of customer portfolios.

The deregulation process and the growing degree of competition in the natural gas market, together with the liberalization of the electricity sector, are leading to an ever more competitive market. In this context, new strategies, which may entail an increase in financial and business risk, are considered. In general, the strategies adopted by companies foresee action directed at the cost structures and redefinition of operations in order to achieve growth in terms of size and efficiency.

Companies are therefore embarking on industrial and corporate restructuring ? with the principal European utilities and the large petroleum companies playing a leading role. This reflects the need for operators to guarantee themselves an adequate competitive position in the relevant energy markets (electricity, natural gas, petroleum).

In the light of increasing operating risks, consolidation becomes the strategic option that may best lead to diversification of the business risk, through the expansion of the customer base and/or of the range of services supplied. This is accomplished primarily by exploiting the company's expertise in managing network infrastructure or by taking advantage of market and technological synergies in contiguous sectors of operation.

One of the main features of the consolidation process is the reorganization of companies' internal structure into functional divisions, in such a way that adequate resources and appropriate managerial skills are exploited in each business line. The ability to develop strong specific expertise is a key success factor for energy sector companies.

The progressive opening of the national markets to competition and, eventually, the formation of a single European market emphasize the importance of company dimensions for operating in the gas sector. Only a few international integrated operators will be able to play a prominent role in the future European gas market, taking full advantage of economies of scale.

One of the fundamental drivers behind the consolidation process is the convergence in the energy sector arising from integrating operations in the electricity and gas industries. The process of convergence is explained by the role natural gas plays in the generation of electricity and heat (upstream convergence), together with the common customer base of the two sectors (downstream convergence).

Convergence is therefore one of the key elements behind the diversification policies pursued by energy sector companies as they move towards a dual fuel or multi-utility setup. This process contributes to increased business risk, although such risk varies between the upstream and the downstream segments. Upstream convergence implies a higher level of risk as it is focused on highly deregulated market segments and requires greater investment. The investments themselves may introduce a further element of uncertainty, the valuation of which may vary according to the selected financial method. Downstream convergence, which is a natural monopoly, is subject to greater regulation and can guarantee a higher stability of revenue flow with a lower degree of risk.

The opportunities for upstream convergence appear to be greater in those countries where the spark spread is higher, i.e. where it costs less transforming natural gas into electricity. With a positive spark spread, operators who have access to natural gas are more inclined to enter the electricity generation sector, as is the case of electricity producers entering the upstream gas segment. Italy, having a particularly positive spark spread, is a market highly suitable to concentration within one company of natural gas production/import and electricity production. Such concentration offers considerable opportunities for the exploitation of the arbitrage margins on the two energy commodities prices.

MCC foresees the following trends in Italy during the near future: an acceleration of the liberalisation process, an increase in gas consumption and further growth in corporate activity among sales operators. Moreover, the most dynamic players are expected to participate in the supply segment of the natural gas value chain. We therefore expect increased investments in import infrastructure in order to align with the foreseen market growth.

Footnote

1 MCC's Industry Research Department, ?Growing up in Public ? The Natural Gas Market in Europe: Focus on Italy?, March 2002.