Submission on the National Third Party Access Regime for Natural Gas Pipelines

Submission

SUMMARY

GENERAL ISSUES

• Competition is a the most potent means of ensuring efficiency but is only effective where there is no arbitrary government intervention creating uncertainties and where property rights are firmly established.
• Where competition is not possible, regulation may be necessary but such regulation should avoid distorting market operations and placing excessive costs on businesses.  It should be designed to bring about similar behaviour of market participants to that which would occur under competition.
• A corollary of the above is that the regulation of pipelines must be limited to where there is natural monopoly and where the regulation itself will produce a better outcome than if the natural monopoly were to be left unregulated.

SPECIFIC RECOMMENDATIONS

• Regulatory coverage should not extend to gathering lines or to processing plant.
• The regime covering pipelines should not normally be extended to new pipelines except where previous regulations prevented such pipelines from being built.
• Entrepreneurs wishing to supply areas not presently supplied should normally be allowed to set their own terms and conditions of supply
• there is no case for competitive tenders unless previous regulatory controls have created an obvious profit opportunity that many suppliers would wish to pursue;  even then the winning tender should not be guaranteed any immunity from competition.
• Regulatory coverage should be withdrawn from all pipelines that are in competition with each other.
• Pricing arrangements for covered pipelines should be based on current cost accounting principles using optimised deprival value.
• There should be no strictures against pricing approaches like "front-ending" or preferred prices to "establishment customers", nor should the pricing horizon be limited to the five years presently stipulated.
• The arrangements under section 8 should be considerably revised as they attempt to introduce principles that are dissimilar from those that prevail in the commercial world.

THE GOALS OF THE PIPELINE CODE

The national access regime for natural gas and the regulatory reform process generally is about improving the efficiency with which the economy uses its resources.  Competition among buyers and sellers is the best means we know of ensuring efficiency but to do so it requires:

• the full and secure knowledge on the part of the suppliers that they will be allowed to retain the gains they make from satisfying sellers by furnishing them with the goods and services they require at the price, quality, location etc. that they require them.
• the ability of the market to sustain competition -- in other words the likelihood that the market can be best served by more than one supplier (and that it comprises many buyers).

Competition is not valued as an end in itself but as the means of promoting efficiency.  This has two aspects.  First, monopoly is likely to mean a waste of resources because the producer's natural interest in maximising profit can be married with an ability to do so through forcing up the price by restricting supply.  Secondly, commercial rivalry is also superior to other arrangements in driving costs down and ensuring the lower cost outcome is passed on to consumers in lower prices.  Competitive firms must constantly seek cost savings and other ways of maintaining or improving their profits and these cost savings are largely converted into consumer benefits as rival suppliers adopt similar techniques.

GENERAL ISSUES ADDRESSED IN THIS SUBMISSION

The one justification for government intervention in the gas industry is market failure stemming from the existence or potential for natural monopoly.

Natural gas supplied by pipeline is rarely, in strict terms, a monopoly good since as a source of energy, electricity, LPG, and other fuels provide substitutes.  Nonetheless, there are monopolistic characteristics in the supply of gas to many communities and users.  These monopoly features were previously magnified by government regulation of competition to existing businesses.

We share the concerns of the Code framers in respect of the case for combating inefficiencies that stem from monopoly provision.  We therefore broadly endorse the need to regulate where monopoly provision of transmission pipelines has been brought about by government economic ⁽¹⁾ regulation a pipeline.  Under such circumstances rules are necessary to ensure fair access to the monopoly facility on the part of users and gas suppliers.  At issue in these matters is the degree to which the requirements for providing information are excessive and the precise pricing arrangements.  The GRIG will receive considerable information on these matters from parties with particular experience.

In addition we have other concerns that regulation, in seeking to combat the detrimental effects of monopoly will create its own deficiencies.  These would stem from:

• insecurities on the part of those whose success may generate increased value in their ability to retain for themselves a large share of that value;  those insecurities may stem from:
• "free rider" problems whereby innovation is discouraged because there is an imbalanced risk/reward outcome;  the innovator gets slender benefit from success because other parties are given a share of the success by Government, while costs of an unsuccessful venture are sheeted home solely to the firm itself;  and
• fears that the Government may take a view on the price that can be charged which will offer inadequate compensation for the totality of risk involved.
• requirements on the part of suppliers to offer more information than they would prefer, thereby revealing profitable opportunities to their competitors or offering their customers excessive bargaining leverage.
• paperburden costs entailed in submitting applications for approvals to regulatory bodies.
an inability to combine different businesses together so that risk is reduced.

While the Code purports to be a light handed approach, it is not flexible.  The provisions for pricing and access are in fact highly prescriptive and where there is flexibility it is often in directions that offer too much discretion to the regulator and thereby reduce certainty on the part of the operator.  Such loss of certainty is likely to raise the return needed to justify pipeline operations and reduce activity in the business.

The Code is concerned to prevent excessive profits on the part of pipeliners.  Such goals have clear merit where a facility is a genuine natural monopoly.  However, the pursuit of "excessive" profits or economic rents is a legitimate business goal and one that almost all firms strive towards.  Suppressing that pursuit will reduce activity and those regulatory measures should therefore be confined to tightly defined and rare circumstances

SPECIFIC MATTERS ADDRESSED

THE FACILITIES COVERED

We would wish to see as little regulation as possible.  For this reason we commend the statement in the NCC Issues Paper that the reach of the regulation is not to extend to upstream producing operations or to gas processing plant.  Both of these are facilities that can readily be duplicated, albeit in certain cases at additional cost.  Moreover, processing plant is in fact a manufacturing facility that is specifically excluded from the ambit of Part IIIA of the Trade Practices Act.

THE ISSUE OF NEW VERSUS EXISTING PIPELINES

Existing pipelines which serve as non duplicable facilities and which face no competition from other pipelines, present a powerful case for regulation of some sort.  Where no pipeline currently exists the regulation on a new line should be minimal.  Yet, in the draft Code, the onus is reversed.  A new entrepreneurial pipeline is required to prove that it should not be covered, and the Code itself would appear to offer few circumstances when this will be accepted.

There will inevitably be many voices raised after a pipeline is committed seeking lower haulage charges.  The entrepreneur will wish to avoid being hostage to such pressures.  To this end, the entrepreneur will require assurances from the regulator on prices, in the absence of which many worthwhile projects will not proceed and in other cases new capacity will be restricted to only that amount which is fully committed at the outset.  In the latter case, the decision is likely to be sub-optimal since the capacity of a pipeline is related to the square of its diameter and the costs of building in incremental capacity are, accordingly, relatively low.

If there is no pipeline serving a place and a new one is proposed, the pipeliner should be free to determine the terms on which it does business.  The community can only gain from the new facility and the pipeliner is constrained in his pricing and other conditions by the ability of rivals to offer a pipeline alternative or by the existence of the pre-existing sources of energy.

The outcome of an entrepreneurial pipeline is seen in Goldfields where WMC/BHP/Normandy took the risks and built a pipeline to supply their own needs. ⁽²⁾  Having done so, the consortium is relatively unconstrained in charging others, including Alinta Gas, a price that is close to what the market will bear.  This appears to be unacceptable under the Code.  Thus, under s.3.14, the arrangements are designed to preclude a pipeline from obtaining any greater profits than the regulator anticipated, and this is further amplified in s.3.23(d)(ii) which requires a tenderer to produce a policy regarding "additional revenue", a provision that does not seem to have a reciprocal arrangement where there is negative additional revenue.

COMPETITIVE TENDERS

The parts of the Code dealing with tenders present difficulties of themselves.  A competitive tender for the construction of a pipeline is an appropriate means of pursuing a development when the Government has determined that there is a market need and there would be many businesses seeking to take up the opportunity.  It is, however, not clear how the Government would have access to that information in advance of profit oriented businesses.  If a profitable opportunity exists to supply an area with a new pipeline, it is most unlikely that the first party to discover this would be a Government agency.

If a private business were to spot an opportunity and subsequently be required to tender for the right to provide the means to meet it, that business will have incurred costs on which other businesses would free ride.  To require the opportunity to be tendered would be analogous to placing similar requirements on the proposers of a new paper mill or smelter.  It would discourage market searching activity and innovation.

Tendering is really only appropriate where there are Government or private monopoly restraints, which have impeded developments that offer obvious profit opportunities.  In such circumstances, or where the pipeline needs government assistance to facilitate rights of way, an auction may be the best way of allocating the rights to the pipeline.  However, the best approach is to remove the impediments which prevent worthwhile developments from proceeding.  In any event, where one party is successful in offering the best price, that party should not be sheltered from future competition including from those parties whose bids were rejected.

WHERE THERE IS PIPELINE ON PIPELINE COMPETITION

The foregoing highlights a further issue.  Where there is adequate competition, no regulation is necessary -- after all, the regulation proposed is nothing other than synthesised competition.

In this respect, the provisions for revoking coverage are unclear.  Although s.1.30 says revocation must be recommended if it is no longer uneconomical to have another pipeline provide the services, the services are not defined.  Revocation is only unambiguous where another pipeline parallels the existing line and there is surplus capacity.  It would not therefore automatically apply to the BHP/West Coast line which provides competition to the Cooper Basin suppliers for the Sydney market.  It is likely that if the BHP/West Coast line is to be covered under the Code, its design and capacity would be affected.

If the Code is not to be an impediment to efficiency and to businesses striking their own deals as they do in other areas of commerce, it should ensure that regulatory oversight is confined to the core areas and does not attempt to provide an insurance to "fairness" or some other notion where rival suppliers are in place.  It follows that where there is more than one pipeline serving an area or passing relatively closely to the same area, unless one of the pipelines is unable to provide competition (because its capacity is trivial compared with the other) coverage should automatically be revoked.

PRICING POLICIES

The pricing basis for existing pipelines leaves too much discretion to the regulator and is likely to be over complex in establishing prices for different services.  In terms of the price base, notwithstanding CoAG agreements that optimised deprival value be used there is provision for other approaches.  At the minimum, pricing must be based on replacement costs -- the alternative sets the price too low and leads to both excess demand for the service and inadequate incentive to increase capacity or build rival lines.

Not only is there too much discretion on the part of the regulator in the price setting methodology, but the depreciation schedules under s.8.30 may lead to different rates for different parts of the pipeline depending on its use.  This will give rise to highly complex and somewhat illogical pricing decisions.

The pricing formula is in general over prescriptive and likely to bring departures from efficiency.  Thus, for example, the embargo against front ending (s 8.31) is difficult to understand.  Typically, many new firms in a competitive market will introduce low prices when demand is being grown and seek to recoup losses in the mature market that grows.  Many new products are priced low to start with -- some are even given away free!.

The tariffs are set on the basis of the Service Provider earning a reasonable revenue.  But price is also the most efficient means of allocating demand between rival users.  If the price is to be fixed, either usage will be misallocated or the users rather than the pipeliner will receive the incentive to construct new capacity -- in other words the incentives are placed with the wrong party.  This is notwithstanding s.8.2 which seeks to offer incentive mechanisms seeking to price so that the market clears.  Use of any depreciation schedule in setting the price is likely to mean the price is too low to attract additional capacity.  Rent controls prevent the building of new houses!

Other deficiencies include:

• While some price regulation may be necessary for existing pipelines, new pipelines under s.8.13 are equally targeted.  Yet any possible customers on a new pipeline route can only be better off as a result of the enterprise.
• The determination of new facility capital bases on which charges can be levied (s8.15 etc) requires the regulator to know as much about the business as the owner.
• The surcharge for "Speculative Investment" (s8.21) is especially cumbersome as an approach and leaves little scope for a rent-seeking entrepreneur to take risks and obtain commensurate rewards.
• The prudent discount provisions under s8.40 puts the pricing fully under the control of the regulator.
• The limit of five years certainty that can be given to the pipeliner in terms of price.

Some of these issues assume particular importance in the derivation of reference tariffs.  These tariffs appear to be determined by the pricing principles in section 8.  There is a danger that such prices would become a price floor, not the price cap that might be justified for a presently existing monopoly pipeline.  In the latter case, there would need to be some price shifting among customer classes for the pipeline to recoup its permissible margins.  There may be occasions where this becomes impossible because the customers refuse to pay a surcharge are unable to bear it, while in other occasions the tariff will have forced a re-weighting between customers which is unlikely to represent a shift towards greater efficiency.

The deficiencies of the present proposals are tacitly acknowledged in the sections of the Code that deal with Queuing policy.  This seems to establish rights to negotiate access to spare or developable capacity based on some time of registering concept.

The appropriate approach is surely to ensure the parties most anxious to obtain the capacity receive it.  This must entail some form of pricing mechanism, perhaps an auction.  None of this is outlined in the Code.  Indeed, the sections dealing with spare capacity (s.5.4, 5.5, 5.6, and 5.7) are designed to place pressure on the Service Provider to release spare capacity.  The procedures to prevent hoarding should be sufficient for this including the requirement that the Service Provider have at least one totally independent director (s.4.4(b)).

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ENDNOTES

1.  Economic regulation is distinguished from technical regulation covering safety etc.  Economic regulation occurs where government controls market operations covering price, competitive entry and quality of product.

2.  In fact, following their original proposal going to tender.