Efficient Gas Transmission in the short and long run

A Basis for Discussion

Prepared for the Gas Industry Company Panel of Expert Advisers

by

Lewis Evans
Professor of Economics
NZ Institute for the Study of Competition and Regulation, VUW

16 December 2011
Key Issues

• The particular matters posed to me by GIC for this meeting

1. What are the market failures in Vector's current access

arrangements?

2. What criteria we should apply to evaluating options for improving

transmission access arrangements?

• From the 7 November discussion these matters imply examination of both

• efficient utilisation of existing pipeline capacity
• efficient investment in pipeline capacity

• The overarching market, or industry, failure is economies of scale in the

presence of irreversibility:

• Institutional failure in access arrangements is present to the extent that

(dynamic) efficiency can be improved by changing these arrangements.
Efficient gas transmission: 16 Dec 2011 2
Topics
• What services do pipelines offer: common and contract carriage
and hybrid?

• Can efficiency of access be treated as an issue separate from

• non-pipeline-specific services?
• investment decision criteria?

• What should we look for in efficiency of pipeline access?

• Possibilities looking forward for the North Pipeline

• Arrangements for existing pipeline
• Capacity expansion criteria/frameworks

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Pipeline Services: Broad Categories
(depends on governance usually mix elements)

a) Common carrier: obligation of the responsible carrier to provide

gas transmission on a pro-rata basis: it pools gas

b) Contract Carrier: provision of capacity under contract:

- long term/renewable in the case of Vector

Open Access may apply (also) to contract carriers, whereby gas pipelines
provide accessibility on a first-come first-served basis to all clients willing
to pay the pipeline's maximum tariff. Once capacity is fully utilized, the carrier
must refuse new clients.

The different arrangements provide different services

• management of volatility
• certainty of delivery and take
• location of any storage

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Pipeline Services and Governance
Under both

• Common carrier:
and
• Contract Carrier: with multiple shippers

There is a single governance entity and the qualities of gas shipped

must be the same for all shippers under both arrangements

North Pipeline at present:

A mix: rough approximation to contract carriage

• Perpetual property rights to granted capacity (renewed annually)
• But with interruptible and over-run services
• Pricing annual
• Capacity fees + interruptible prices + overrun prices
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Common vs Contract Carriage Effects I

• Contract Carriage is vertical integration with “contracting in” producing

“owned” capacity

• Common Carriage induces vertical separation between markets

• Comparison thus rests on factors determining whether vertical

Integration or separation in supply arrangements is efficient

• For Common vs Contract Carriage: factors would include

• The state of competition in upstream and downstream markets
• Coordination and surety of shipment (upstream investment)
• Footprint of the gas network(s) and
• The state of storage

Efficient gas transmission: 16 Dec 2011 6

Common vs Contract Carriage Effects Compared II

• The state of competition in upstream and downstream markets matters

• Competitive in both: no issue
• Few firms in both: double marginalisation: contract?
• Few firms in up/competitive in downstream: contract?
• Few firms in down/competitive in upstream: common?

• Surety of transport/governance: medium vs short term

• Medium: require surety of transport for upstream investment

• Short term possibility of opportunistic entry/exit may affect investment
• Medium/short term: where is storage located (upstream or downstream:
which is the more costly?). To what extent does the final consumer bear
supply risk?

Efficient gas transmission: 16 Dec 2011 7

 Efficient Capacity: Common vs Contract Carriage compared recap

• The definition of pipeline capacity may differ somewhat under each

because they coordinate shipper flows differently: e.g. it may be that higher
aggregate flow is achievable under common carriage but also higher storage costs

• Each of the governance structures’ social costs and

benefits and hence efficiency differ depending on the factors – e.g. competition,
storage, risk management etc.
• Thus “capacity that drives investment” or that is efficient will not
necessarily be at the same level of aggregate throughput for contract as for
common carriage.

• The social investment criterion, however, should remain the same: but should
Incorporate all effects (e.g. storage implications).

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Efficiency At Capacity: recap
Assuming full utilisation of capacity

• The price consumers face will clear the market

• Fixed supply (capacity) and demand equals supply fixes the price
• Lower prices imply consumer-customer queues

If demand grows price to consumer rises

• Consumer surplus may or may not change (as supply is
fixed)
• Producer surplus will rise to holder of capacity under
either common or contract carriage
• Producer surplus will be held by the holders of capacity
rights if not the governing firm

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 Investment in additional Capacity: recap

Social timing/quantum
Invest when expected present value of additional total surplus exceeds K (≥ 1)
times expected present value cost of investment

Private timing/quantum
Invest when additional present value extra profit (producer’s surplus) exceeds
K* (≥1) times cost of the expected present value of investment

Private may be close to social (public) timing/quantum when there are

fixed and variable charges, since these can scoop off some consumer surplus

Efficient gas transmission: 16 Dec 2011 10

Pricing of Carriage and Efficiency: pipe unconstrained

Common Carriage

The service is quantum of gas shipped and hence the price should be $/GJ/period
transhipped

Contract carriage (at least two shippers)

The service is capacity: and the price of the service should be

Fixed charge/ capacity

But

Funding investment appropriately will generally require fixed and variable charges
in order that the pipeline be funded and produce the “right” throughput: i.e. require
two (or more) part tariffs

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Why fixed and variable charge?

Efficiency requires fixed and variable charges ex post variable charge may not
cover cost

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Efficient Pricing constrained pipe: common carriage

Once physical capacity of the pipeline is reached price should rise to the point
that an additional chunk of capacity is justified (recall that the price is only a
partial signal): Where capacity is reached there is an argument that a fixed charge
be introduced as an additional signal.

Because of scale economies there will need be a fixed charge for self financing
pipelines

Efficient gas transmission: 16 Dec 2011 13

 Efficient Pricing constrained pipe: contract carriage I

Contract Carriage capacity: occurs when the feasible physical capacity of

the pipeline has all been contracted

Once contract capacity of the pipeline is reached the price to consumers

of capacity should rise to clear the market: under contract carriage may produce
rents for holders of capacity rights

Again price (in this case the fixed charge/capacity) is only a partial signal .

Because fixed charges scoop off some consumer surplus the capacity price is a
better indicator of investment desirability

Efficient gas transmission: 16 Dec 2011 14

 Efficiency constrained pipe: contract carriage II

Under contract carriage there may be capacity unused but paid for by a shipper
is this efficient?
• It can be e.g.
• where it provides a shipper with surety (a real option) for future use:
perhaps attendant with upstream investment and downstream costs of
storage;
• Where it provides a shipper the ability to absorb almost all of its
customer supply risks

• It may not be
• where a shipper seeks to limit downstream competition : this is more
likely where upstream competition is relatively more vigorous than downstream
• Where transactions costs inhibit transfer of capacity by individual capacity-holders.

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Efficient Pricing at Capacity: contract carriage constrained pipe

A. If total capacity is contracted: and down-stream demand continues to grow and total
capacity is priced fully
• There will for contract shippers be increased direct or opportunity costs in holding
spare capacity, and
• The threat of an additional chunk of capacity (investment) on the horizon

B. If transactions costs are low enough - as where a market maker provides

matching services for demanders and suppliers of capacity - voluntary exchange of
excess capacity may occur . If it does these exchanges will improve efficiency as
they will increase throughput.

Under the contract model these (subcontract) exchanges may have various terms but they
need be written around capacity.

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Hybrid of Common/Contract Carriage Capacity

A pipeline that is managed for either contract carriage or common carriage has the
governance structure that might contemplate a mix of approaches. It could

• Contract out capacity to shippers for a proportion of the existing capacity and
• Manage the remaining capacity as common carriage

In this setup

• the common carriage capacity would be priced to the network manager as

any other capacity; and the network manager would price the throughput of its capacity
under common carriage capacity per GJ trans-shipped (may be two part tariff);

• contract holders of capacity would be charged for capacity and they could voluntarily
trade their capacity with other shippers or the network manager for utilisation as
common carriage.

Efficient gas transmission: 16 Dec 2011 17

 Vector and the
Hybrid of Common/Contract Carriage Capacity

If Vector has any un-contracted capacity in 2011 or the future it could

• Auction it off under capacity contracts, or

• Use it as the basis of common carriage.

At the same time shippers with capacity could trade capacity with Vector’s
pool or other shippers

Efficient gas transmission: 16 Dec 2011 18

 Vector and the
Hybrid: does it differ from present arrangements?

Does this usefully differ from the present arrangement:

• Does it maintain/develop property rights under contract and

pool systems
• Does it provide a manager of the pool and market maker for trading jointly?
• Does it provide a more active manager (pool particularly)?
• Does it facilitate trading by contracted parties (and with the pool)?

Need consider
• Vector’s position under regulation, and
• How governance interacts with the investment framework

Efficient gas transmission: 16 Dec 2011 19

 Investment Framework
Some Preliminary Background Questions

Some issues are so important they may affect the framework for investment
as well as the assessment of individual capacity investments

• Does the presence of the North pipeline mean that bypass pipelines
have a significant cost disadvantage vs North pipeline owner? i.e. are
economies of scale that important?

• How does storage at the downstream end of the North pipeline

compete with pipeline capacity expansion costs?

• How economically feasible is as Liquified natural gas import terminal

downstream of the North Pipeline? (or similarly located discoveries)
Framework determines:
a) timing of investment, b) risk sharing, c) factors to include in appraisal

Efficient gas transmission: 16 Dec 2011 20

 Summary Comment on Investment Framework I
Governance (Vector) regulated to “normal” profits:
no pipeline bypass

Pure common carriage:

• Fixed plus variable charges: but Vector cannot have any scarcity
rents
• Implies some disequilibrium at full capacity (who gets the
rents?)
• Investment by Vector will generally require regulatory approval:
and
• Vector make the investment and be allowed risk adjusted
rate of return: ex ante and ex post
• Regulated pricing on all assets: such that investment is at
least commercially viable:

Efficient gas transmission: 16 Dec 2011 21

 Summary Comment on Investment Framework I
Governance (Vector) regulated to “normal” profits:
no pipeline bypass

Pure contract carriage investment:

• Fixed/capacity charges: but Vector cannot hold scarcity rents
• Equilibrium at full capacity: contracted parties hold any scarcity rent
• Investment as previous slide, or
• Funded by representatives of prospective gas shippers under long term
contracts that fund extra capacity put in place by Vector

Efficient gas transmission: 16 Dec 2011 22

 Summary Comment on Investment Framework II
Governance: Unregulated Bypass option: (Vector) regulated to “normal”
profits

• Pure common carriage:

• Investment favoured for Vector under mechanism described
above
• Other providers would need to fund the investment themselves
speculatively (unlikely to be timely)

• Pure contract carriage: as above or investment might await additional gas

shipping to enter long term contracts that fund bypass capacity
put in place by a) themselves or b) Vector

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And Hybrid ? combinations of these approaches

Efficient gas transmission: 16 Dec 2011 24

 Final Comment

Key issue: what governance arrangements are appropriate in a

situation of piecemeal (small demanders) growing demand and
North Pipeline at capacity during the period when additional
capacity is not socially/privately justifiable?

Efficient gas transmission: 16 Dec 2011 25