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Regulation in oil and gas pipelines

Introduction
Until recently the Indian hydrocarbons industry had been highly regulated. After the nationalization of oil companies in 1976, the first initiative to attract private sector participation was launched in the upstream sector to augment domestic crude and gas production. On the downstream side, the government decided to allow private investment in oil refining in 1987. Next, lubricant base stocks were decanalized in 1992 and parallel marketing of SKO (superior kerosene oil), LPG (liquefied petroleum gas) and LSHS (low sulphur heavy stock) was introduced in 1993. The Ninth Plan estimates pegged the investment requirements to create the necessary infrastructure to meet the demand for petroleum products in the country at Rs 1240 billion. It was recognized that such a scale of investment was not possible by the government or the public sector oil companies. Participation of private capital from both domestic and international sources was considered imperative. The then prevailing regulatory regime, namely APM (administered price mechanism), divorced form economic realities, was considered far from suitable for attracting private capital. In 1995, the government appointed a strategic planning group on restructuring of the oil sector (the R Group) to make recommendations to meet the policy objectives and initiatives required for restructuring of the oil sector. In September 1997, the Government decided to dismantle the APM through phased reforms, as recommended by the R-Group. To evolve a strategy to shift towards a market-driven pricing system, the government prepared an approach paper for the restructuring of the oil sector. As a followup, the government appointed an ETG (expert technical group) in 1996 to review the prevailing pricing system and examine the sectoral impacts of different levels of duty in case of dismantling of the APM. In November 1997, the government announced the details of the phased dismantling of the APM as per the recommendations of the ETG. Full deregulation of the hydrocarbons sector is expected by April 2002.

Distribution: Current scenario

Petroleum products
Effective November 1997, refinery gate prices of petroleum products were linked to import parity except for controlled products, namely MS (motor spirit), HSD (high speed diesel), SKO, LPG, and ATF (aviation turbine fuel). In addition, while consumer prices of controlled products were linked to a phased import parity (except HSD), prices of other petroleum products were decontrolled. Under the present scheme, with the government retaining controls on prices of controlled products, the ex-storage point prices of controlled products at main installations are uniform throughout the country. Prices at upcountry depots or installations are determined on the basis of prices at the nearest supply source (refinery/main installation) plus costs of transport by the cheapest means. Product distribution is implemented by the OCC (Oil Co-ordination Committee). Each month, based on product demand and refinery production in each region/zone, the OCC works out a detailed distribution plan (supply plan movement) specifying loading bases, volumes, dispatch modes, receipts, etc. In the case of pipelines, the OCC details pumping schedules for products, share of companies at tap-off points, tap-off point stocks, etc. While bulk of the product movement is through railways, the share of product movement by pipelines as a percentage of total consumption has increased significantly over the years (Table 1). Table 1 Share (%) of rail and pipelines in the transport of oil products: 1990/91 to 1998/99
Year 1990/91 1991/92 1992/93 1993/94 1994/95 1995/96 1996/97 1997/98 1998/99 Transport by pipeline 22.9 23.2 23.3 24.6 23.6 22.0 24.9 26.5 28.2 Transport by rail 47.6 47.3 47.0 44.8 44.3 41.7 38.4 39.8 40.0

The development of new pipeline infrastructure for petroleum products is being primarily undertaken by PIL (Petronet India Ltd). PIL was formed as a financial holding company to develop petroleum product pipeline infrastructure in the country through its joint venture companies and subsidiaries on a common-carrier basis. The equity structure of the company is such that the public sector oil companies, namely IOC (Indian Oil Co.), HPC (Hindustan Petroelum Co.) and BPC (Bharat Petroleum Co.) each has a 16% stake in the venture while IBP holds 2% stock. The balance 50% has been subscribed by financial institutions and private companies. A number of pipelines proposals have been taken up by the company (Table 2). Table 2 Proposed product pipelines by Petronet India Ltd.
Pipeline CochinKarur MangaloreBangalore Chennai-TrichyMadurai Central India Pipeline Bina-JhansiKanpur BhatindaJalandhar Jammu Paradeep RourkeeRanchi Sponsors PIL, BPC, CRL PIL, HPC, MRPL PIL, IOC, MRL PIL and oil companies PIL, BPC, BORL PIL, HPC, JV refinery PIL, IOC, JV refinery Completion Schedule November 2000 October 2001 March 2002 September 2002 To coincide with the commissioning of Bina refinery To coincide with the commissioning of Bhatinda refinery Coincide with the commissioning of Paradeep refinery

The CIPL (Central India Pipeline) project, originally intended to be executed by PIL, has been recently approved for award by the PIL board to a joint venture of Indian Oil Corporation and Reliance Petroleum Ltd on a buildown-transfer-operate basis. In their proposal for CIPL, IOC and RPL have estimated a cost saving of about Rs 15 billion by dropping the spur lines planned for Indore, Bhopal, and Chittorgarh.

Natural Gas
As regards the gas transmission and distribution network is concerned, a system about 5425 km long is currently in position, bulk of which is owned by GAIL (Gas Authority of India Ltd.) The largest pipeline system is the HBJ (Hazira BijaipurJagdishpur) trunk pipeline system, which is more than 2000 km long. The capacity of the HBJ system was expanded from 18.3 MMSCMD (million standard cubic meters per day) to 33.4 MMSCMD in July 1998. In addition, there are regional gas grids of varying sizes in Gujarat (Cambay Basin), Andhra Pradesh (KrishnaGodavari Basin), Assam (AssamArakan Basin), Maharashtra (ex-Uran terminal), Rajasthan (Jaisalmer Basin), Tamil Nadu (Cauvery Basin), and Tripura (Arakan Basin).

Figure 1 Gas transmission infrastructure in India GAIL is planning to enhance the capacity of the HBJ pipeline system from 34 MMSCMD to 60 MMSCMD to cater to additional gas availability for the proposed LNG (liquefied natural gas) terminal at Dahej. GAIL is also planning to add new pipelines in the Krishna, Godavari, and Cauvery basins with prospects of additional gas availability in southern India. In addition, US-based Enron International is planning to float a dedicated company for its proposed pipeline ventures in India through its affiliates with an equity investment of about $60 million. The company is planning to float a new

company, MEC (Maharashtra Energy Company Private Ltd.), to construct and own low-and medium-pressure natural gas pipelines. Initial plans involve construction of feeder pipelines from the LNG regasification plant at Dabhol. Meanwhile, GSPL (Gujarat State Petronet Ltd) is implementing a 1600-km long gas grid in the state of Gujarat. GSPL was incorporated as a special purpose vehicle by the Gujarat State Petroleum Corporation in December 1998, specifically to implement the gas grid for the transmission of LNG from import terminals to demand centres across the state. The adequacy of the proposed networks to cater to future requirements is yet to be adjudged and would require a detailed analysis. In the case of gas networks, the need for local state-level networks as in Gujarat has already emerged with the proposed LNG terminals. Likewise, new local distribution networks may also be required when imports via pipeline from Iran and Bangladesh fructify.

Need for regulation

While movement by pipelines is irrefutably the least-cost option for product movement, for transmission and distribution of gas, it is the sole option. In addition, product movements by pipelines requires much less energy than by other modes. Trends in the modal shares confirm this. While current market shares for petroleum products are dictated by the sales plan entitlement scheme, market volumes in a deregulated scenario would be based on the competitive advantage that one company enjoys with respect to another, be it service, technology, quality, marketing skills, or prices. Given that distribution expenses contribute significantly to retail prices at the consumer end, a firm can exercise competitive advantage by streamlining its distribution system. Access to pipelines, which offer the most economic mode of transport, would thus be critical in a deregulated scenario. Key reasons generally cited for pipeline regulation as follows. Pipelines exhibit technical economies of scale Pipelines are not subject to significant inter-modal competition Pipelines construction is capital intensive, implying appreciable barriers to entry Studies conducted by the US Federal Energy Regulatory Commission have indicated that pipelines exhibit economies of scale (IEA 1994). Their studies revealed that as a pipeline grows in capacity, its costs increase less

than linearly while throughput increases exponentially. Thus, pipelines have decreasing average and marginal costs of production. Given sufficient volumes, the larger a pipeline is built, the lower the tariff required to produce a certain net return on investment. A pipeline could, thus, be a natural monopoly in the area it serves, since expansion of capacity results in a reduction in costs per unit transported. In most countries, a common way of regulating a natural monopoly has been some form of a rate of return limitation. In addition, it is generally accepted that a competitive environment induces self-regulation. However, it is inconceivable that a new entrant could duplicate existing pipeline infrastructure and offer products at competitive prices to that by an existing player. In summary, thus, pipeline regulation is warranted on two counts, (a) to limit the profits of an unregulated monopolist and (b) to offer a level playing field to all players (fostering a competitive environment).

Issues in pipeline regulation

Before moving on to issues in regulation, one must examine forms of regulation. There are three types of regulation relevant to pipelines. Structural regulation; wherein a regulatory authority determines which firms can or must engage in particular activities. Conduct regulation; which involves measures to control the conduct of a firm. Use of standards; which shape the behaviour of firms in areas related to health, safety, and pollution. Given the need and form of pipeline regulation, two key issues emerge, namely open access and the other tariff setting.

Mandatory open access

In the Indian context, the term MOA (mandatory open access) is preferable to third party access. The Commission of the European Communities defines third party access as a regime providing for an obligation, to the extent that there is capacity available, on companies operating transmission and distribution networks to offer terms of use of their grid, in particular to individual consumers or distribution companies, in return for payment (IEA 1994). The term mandatory open access is intended to cover both rights that are directly enforceable by virtue of explicit legislation and general obligations.

The preference for MOA stems from the following. First, the issue of ownership. It may be noted that as far as onshore product pipelines are concerned, out of a total length of 5037 km (as of 1 April 1999), the IOC owns 3950 km (MoPNG 1999). Likewise, for onshore gas pipelines, out of a total network of 4787 km, claims ownership to 4017 km. Under the APM regime, asset ownership has had little impact on operations, primarily due to the fact that all marketing operations have been conducted by public sector oil companies. Distribution of controlled products, including that via pipelines, is coordinated by the OCC, which ensures product availability to all players. The situation is likely to be quite different in the deregulated scenario with the entry of private players and even amongst public sector oil companies. Given the ownership pattern, both IOC and GAIL are in a position to exert monopolistic influence on the existing networks. Next, one needs to examine the issue of conditional access subject to spare capacity in a pipeline in the third party access regime. Evaluating a deregulated scenario, one does not expect higher volumes on account of entry of new players; only the individual shares of players would change. It stands to reason, then, that if the total volume in question remains the same, unconditional access should be allowed to the existing networks for all players to ensure a level playing field to all marketers. As volumes build up eventually, new infrastructure could be developed by new players, which would again be on MOA mandatory open access terms.

Review of prior studies

It may be noted, however, that, prior studies on this issue have recommended common carriage (interchangeably used with the third-party access) with regulatory oversight. The third report of the ETG dealt with pipeline tariffs and compensation mechanisms for marketing operations. The ETG recommended the adoption of the common carrier principle for pipelines. The common carrier principle, as defined in the ETG report, is a system whereby a pipeline transports products owned by any oil company without differentiation in tariffs offered to various shippers. The common carrier principle offers no competitive advantage to the pipeline owner and allows third party access on a nondiscriminatory and transparent basis. The ETG report also recommended the jurisdiction of a regulatory authority to oversee the implementation of the common carrier principle. More recently the subject was dealt by the sub-group on restructuring of the oil industry, including dis-investment, role of the government and regulatory

structures under the Hydrocarbon Vision 2025 Group. The following is an excerpt from the sub-group report.
One of the main infrastructure requirements for a marketing company would be access to a pipeline to evacuate its products. Most commonly followed method of pipeline regulation the world over is the common carrier principle with a right of access to all players. While the ownership of existing pipelines would remain with present owners, the regulatory authority set up would regulate the access to others, as also the tariffs for the pipelines. Though, the owner will have right of first use to the extent of owners requirements, the regulatory authority would force expansion of capacity for the use of the pipeline by other player.

Analysing the recommendations, one finds that though the sub-group has advocated the common-carrier principle, additional emphasis has been laid on ensuring access to all through forced expansion of capacity, in effect calling for the institution of an MOA system.

Associated infrastructure
It may be noted that prior studies have not addressed the issue of such associated infrastructure as tap-off points and tankages. Mandatory open access to a pipeline is meaningless without access to associated infrastructure. Pipelines and associated infrastructure ought to be considered as a single integrated entity MOA applicable to the entire system. In summary, there is ambiguity regarding the status of existing pipeline infrastructure in a deregulated scenario. Full deregulation of the hydrocarbons sector is expected by April 2002. Deregulation of the sector without addressing this issue would provide current network owners undue competitive advantage, distorting the competitive environment. There is, hence, a pressing need for the Government to take an expeditious decision on this issue.

Tariffs setting
Tariff setting is a complex exercise, the complexity being particularly high in the case of an existing pipeline to which access is requested by new players. In matured markets, one may expect independent ownership of pipelines, wherein the marketers are different from pipeline owners. In the Indian context, Petronet India Ltd, a joint venture financial holding company engaged in setting up of pipeline infrastructure on a open access system, was formed only recently. In most cases, thus, one expects to find a situation wherein new shippers are keen on accessing pipeline infrastructure owned by another player.

In such a scenario, pipeline tariffs may be guided by floors and ceilings. For a new shipper, the maximum tariff (ceiling) that can be paid is equal to his opportunity cost, i.e. what the shipper expects to pay for an alternative mode of transport. From the owners point of view, the minimum tariff (floor) is dictated by the short-run marginal cost, i.e. the additional cost of increasing the system throughput by one unit. Clearly, a workable solution lies only when the opportunity cost of new users exceeds that of the owners. Tariff regulation per se can be formal as in the case of United States and Canada or a light handed system as in Germany. In countries like Germany and Norway, authorities indirectly influence tariff levels by recommending a certain rate of return for pipeline projects or by acting arbitrators in cases of dissent between pipeline owners and shippers. In other countries, as in the case of US where tariffs regulated by the FERC (Federal Energy Regulatory Commission), a formal tariff setting procedure is established which considers the following points. The overall cost of service, i.e., the overall revenue needed to cover the pipelines operations, including a just and reasonable return Functionalisation of the costs to identify cost centres, i.e., transmission, storage, etc. Categorization of costs into fixed and variable elements Cost allocation for different rate zones Assessment of unit rates for billing purposes

While the process seems straightforward, the actual task is fraught with complexities. As defined by the FERC, cost assignment is a means for accomplishing a complex of sometimes contradictory goals and for reconciling often conflicting interests in the process of assigning revenue responsibility among the pipelines diverse services and customers. The regulator would, thus, have to weigh all considerations by integrating cost factors with non-cost factors and policy considerations to fashion reasonable tariffs. On home grounds, the ETG tariff recommendations, guided by the above considerations, also factored the telescopic pricing system adopted by the railways. Accordingly, the Groups recommendations incorporated a two-slab tariff structure wherein the user pays a higher tariff for shorter leads up to 300 km and a lower tariff for longer leads. In addition, in order to encourage investments in pipelines, it was recommended that a higher tariff be applicable in the initial three years of pipeline operation. The tariffs also allowed annual escalation at 80% of the inflation in the wholesale price index (WPI). However,

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pipelines costing less than Rs 1 billion were excluded from the proposed structure. As mentioned earlier, ETG recommendations await the governments decision.

Issues to be discussed
Product distribution costs contribute significantly towards the consumer prices at the retail end. Access to pipelines, which offer the most economical form of product transfer, is thus critical. However, unregulated pipelines could be natural monopolies in the areas that they serve. Pipeline regulation is thus warranted to limit the profits of an unregulated monopolist and to ensure a level playing field for all players. The preceding sections provide a brief background on the scope and forms of regulatory systems in pipeline networks. Key issues with respect to the same are summarized below for further deliberation.

Carrier Status
The following issues emerge regarding the carrier status, Contract carriage, wherein a pipeline provides transportation service for those who buy space in its lines, or common carriage? If the common carrier principle is adopted, then should it be mandatory open access or third party access? It may be noted that these terms have been used interchangeably in the literature by different authors. Further clarification regarding the precise connotations of the above-mentioned is thus necessary.

Tariff setting
The key issues in tariff regulation include the following. What should be the form of tariff regulation: price caps, as in the case of United Kingdom, or rate of return regulation, as in United States? What constitutes a reasonable rate of return? Should the tariff be a two-part tariff, covering fixed and variable elements, or a single-part tariff? Should the tariff be distance-related or a fixed postage-stamp tariff?

It may be noted that under the present system, tariffs for pipeline use are insensitive to distance moved. In the case of gas, while the availability is restricted to the western region, this system has facilitated gas-based industrial development along the HBJ up to the northern state of Haryana. A shift to

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economic fuel costing (distance-related) would have probably precluded the use of gas in northern India, as other fuels would have been more competitive. The system, however, places customers in the vicinity of supply sources at a disadvantage. The continuance of the existing policy, thus, needs to be evaluated. Tariff structure, in turn, influences demand for gas/petroleum products. A two-part tariff is likely to encourage occasional use of product/gas, as it precludes reservation charges. In addition, the segregation into fixed and variable components offers a hedge against fluctuations in pipeline flows, encouraging investments in pipelines.

Jurisdiction
With regards to jurisdiction, the following issue emerges, namely should there be separate regulators for inter-state and intra-state pipelines? The state governments I have raised the issue of jurisdiction of a national regulator over state-level infrastructure. The Government of Gujarat is keen on having a state-level regulatory agency for gas whereas the Government of Tamil Nadu is reportedly evaluating its regulatory options. However, there could be other state governments not keen on developing state-level regulatory mechanisms. Such situations may warrant the national regulator to step in to regulate at the state level.

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References
IEA. 1994 Natural Gas Transportation Organisation and Regulation Paris: Organisation for Economic Co-operation and Development, International Energy Agency. 344 pp. GOI. 1999 Hydrocarbons Sector:pipelines and marketing operations New Delhi: Report of the Expert Technical Group, Government of India. 63 pp. GOI. 2000 India Hydrocarbon Vision 2025:- report of the sub-group on restructuring of oil industry, including disinvestment, role of government and regulatory structures New Delhi: Government of India. 37 pp. MoPNG. 1999 Basic Statistics on Petroleum and Natural Gas New Delhi: Ministry of Petroleum and Natural Gas, Government of India. 220 pp. MoPNG. 2000 Annual Report 1999-2000 New Delhi: Ministry of Petroleum and Natural Gas. 50 pp.