A speech to the Prudential-Bache Conference on Gas Marketing,
Sydney, 31 March 1998.
INTRODUCTION
Regulation of the electricity and gas industries covers many different facets. These include:
Rather than repeating the descriptions that have already been covered, in this address I want to focus on some of the possible outcomes and deficiencies of the structural and regulatory arrangements that governments are introducing.
DIMENSIONS OF REGULATION
It is significant that the newly emerging electricity and gas markets have had a different birth from that of any other market structure that has emerged. In general markets can be categorised in two ways: commodity markets and those based on direct relationships between buyers and sellers.
Commodity markets developed from the common interests of buyers and sellers wishing to come together so that they can conveniently compare each others product offerings, assess prices, seek to defray risks by arranging for future delivery. The coffee houses in which merchants exchanged what we now call derivatives grew gradually and spontaneously. Other markets developed as sellers, or occasionally buyers, sought out specific opportunities to trade either by establishing contact with customers or suppliers or by setting up shop.
In both cases the rule of law, known and accepted property rights and mutual trust was essential to the development of the market system. That is why it grew most fruitfully in Western Europe where there was a system of law and ethical standards that gave people the confidence to specialise and transact rather than remain totally self sufficient.
Markets that grew autonomously were the key to the growth of the modern economy and present living standards.
It is therefore something of a concern that the utility markets have been developed by governments rather than evolving from the voluntary interactions of buyers and sellers.
It is perhaps partly because of this that we have institutions in gas and electricity with vast rule books. Of course, the essential facility nature of many of the services in the industry make it different from that of many others. But Byzantine structures are in place to provide checks and balances.
DIFFERENCES BETWEEN THE STATES
The freedom of gas consumers to seek out their own sources of supply varies considerably between the jurisdictions. New South Wales is moving most rapidly towards the open market and Western Australia is the slowest. Table 2 illustrates the timetables
| Table 2: Gas Deregulation Timetables | ||||||
| Timing | NSW | Vic | Qld | WA | SA | ACT |
| end 1997 | 100 Tj | 500 Tj | ||||
| end 1998 | 10 Tj | 500 Tj | 250 Tj | 100 Tj | 10 Tj | |
| end 1999 | all | 100 Tj | 10 Tj | all | ||
| end 2000 | 5 TJ | 100 Tj | all comm. | |||
| end 2001 | all | all | all | |||
While these regulatory matters on gas and electricity are irritants that might offer incumbents in some States certain advantages, they are not fundamental flaws. A further potentially vexing issue in gas is the different regulatory bodies. Although the Code is to be the basis of decisions, its frailty which I will address shortly, can be magnified by the existence of different State regulatory bodies.
COMPETITION AND MARKET FAILURE
Market failure is a rather misunderstood term. It is a precise term in economics that refers to the inability of markets to provide the lowest cost solution because of the occurrence of monopoly. It is sometimes used by regulators as a term to portray a market outcome that does not accord with what they expect to occur.
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.
These criteria must be used to assess the merits of the gas regulatory code.
THE NATURAL GAS PIPELINE CODE
The Intergovernmental Agreement on access to natural gas pipelines was signed in November of last year, at the heart of which is the Code.
The foundation of the agreement is "free and fair" trade in gas. But the means which seek to achieve this are very heavy handed regulation. Hence, while it is an improvement on the State based monopoly regimes that presently exist it does not pave the way for free market entrepreneurial action. 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. While the Code purports to be a light handed approach, it is not flexible.
The Code is concerned to prevent excessive profits on the part of pipeliners. It has four principle objectives:
- to provide open and transparent processes for establishing access to pipelines;
- safeguard against abuse of monopoly power;
- allow customer freedom of choice;
- provide rights of access to pipelines on "reasonable" conditions.
All but the third of these goals are interventions into business decisions.
Such goals have clear merit where a facility is a genuine natural monopoly. They seek to prevent firms gaining monopoly profits. 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.
GENERAL ISSUES
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.(1) 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.3.28, the arrangements are designed to preclude a pipeline from obtaining any greater profits than the regulator anticipated, and this is further amplified in s.3.33(e) 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.
SPECIFIC ISSUES
There are concerns that gas 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.
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 discouragement of 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)).
CONCLUDING COMMENTS
Australia is not alone in embarking on a Brave New World in electricity and gas marketing. The design of the market structures has involved considerable expertise and ingenuity on the part of a great many people as we turn the old centrally planning and centrally supplied markets on their heads. There are clearly vast gains already being reaped in the economy from a market rather than government owned system.
The very high prices being paid for transmission systems in gas and electricity indicate a view among buyers that the existing revenues can be increased. There are four ways that this can be brought about: by squeezing out costs, by inventive tax related schemes based on the interface of different depreciation provisions overseas, by growing the businesses and by banking on persuading the regulator to grant rate increases. Probably all four are in the minds of the buyers but only two of them -- and the two which offer least prospects -- can be said to be wealth generating in the real sense.
I am conscious that I have said little about state gas market arrangements and particularly the contrived bidding market proposed for Victoria. Whether or not such a spot bidding requirement needs to be created remains open. In many respects its construction is founded upon the monopoly held by Esso/BHP. The Wagga link may well be sufficient to break that monopoly and create a more spontaneous derivatives market.
FOOTNOTE
1. In fact, following their original proposal going to tender.
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