Transport costs and domestic gas prices

Transcription

1 Transport costs and domestic gas prices October 2016

2 Table of Contents 1 Executive summary Summary critique Conclusions unaltered by market power of GBJV (to the extent it exists) No compelling evidence that regulation would actually materially reduce transport costs 3 2 Introduction 5 3 The ACCC s economic model ACCC s assumption that Queensland gas prices ± transport costs determine range for southern prices With gas flowing north, lower transport costs are likely to raise southern gas prices Notwithstanding northern flows, the ACCC focuses on the buyer s alternative due to perceived lack of southern competition 11 4 ACCC economic model with GBJV market power ACCC model with market power Cartelisation vs unilateral action by GBJV 15 5 Evidence does not support ACCC contention Gas flow and GBJV output data does not support ACCC concern No explicit model of GBJV conduct provided by the ACCC 20 6 Assumed link between LNG netback and domestic prices 22 7 The relevant measure of transport costs is shippers marginal (not average) costs Shippers marginal transport costs do not equal their average tariff Regulation will not necessarily reduce transport costs either marginal or average 26 8 ACCC Box 8.3 analysis of transport costs and STTM market prices is flawed 29 i

3 Appendix A Netback price is a long run concept 32 A.1 LNG netback price is not likely to be meaningful short run concept 33 Appendix B Withholding supply more costly absent liquid southern markets 37 ii

4 List of Figures Figure 1: Supply and demand scenario with northern flows... 7 Figure 2: Excerpt from section of ACCC enquiry report... 9 Figure 3: Capacitytrading.apa.com.au/gasflows.aspx (6/10/16) Figure 4: Simplified ACCC model of gas market Figure 5: GBJV restricts supply to southern states Figure 6: GBJV restricts supply to southern states Figure 7: SWQP western haul firm allocation vs firm MDQ Figure 8: SWQP eastern haul firm allocation vs firm MDQ iii

5 1 Executive summary 1. Table 6.2 of the east coast gas inquiry shows a one-for-one reduction in the price of gas in Sydney (AUD$/GJ) associated with a 10% to 50% reduction in gas transport costs. The ACCC speculates such a drop in transport costs could result from the imposition of price regulation. 1.1 Summary critique 2. Table 6.2 leaves the reader with the impression that reducing transport costs would alleviate current pressure on southern gas prices that is currently resulting from high net demand for gas by LNG exporters (discussed elsewhere by the ACCC Inquiry). However, this impression is not only inconsistent with the available evidence, including as described in the Inquiry report, but is also inconsistent with the theoretical predictions of the ACCC s own model of how gas prices in southern states are set. 3. In relation to Table 6.2 the ACCC states: Table 6.2 shows the impact of reducing transportation charges payable on the MSP and SWQP/ QSN on the LNG netback prices in Sydney 4. This is not an accurate description of what Table 6.2 shows. Table 6.2 shows the reduction in Sydney prices if, and only if, gas is flowing south from Queensland (Wallumbilla) to southern states. If gas is flowing north from southern states to Queensland then the opposite will occur lowering transport costs will raise southern gas prices. 5. This is no different to any other market where the profit motive causes goods to flow from low priced locations to high priced locations. This flow closes the gap in prices between the locations until the price difference is equal to the cost of transport. That is, until it is no longer profitable, after accounting for transport costs, to buy the good cheap in the low priced location and sell it in the high priced location. 6. Consistent with this general principle, the lower are transport costs: The lower are prices in the high priced location; and The higher are prices in the low priced location. 7. It is therefore critical to ask which is the (relatively) low price location, southern states or Queensland? If southern states are the (relatively) low priced location then lowering transport costs will raise prices in southern states. This makes intuitive sense. Transport costs are a real economic cost of goods flowing from the low priced location to the high priced location. The higher is this economic cost the smaller will be the flow and the more of the good that is retained for sale in the low price location. 1

6 8. The evidence presented in the ACCC Inquiry clearly suggest that, in fact, southern states are the (relatively) low priced location and that gas is flowing north from southern states to the higher priced Queensland market. This is precisely as one would expect given, as the ACCC itself states: 1 It is uncertain if the rapid growth in the combined demand of the three LNG projects will be matched by an increase in gas production over the life of the LNG projects. This has precipitated uncertainty about the future supplydemand balance in the east coast gas market. This uncertainty has been exacerbated by GLNG purchasing substantial volumes of gas in the domestic market over the past five years to supplement production from its currently inadequate reserves. A large portion of this gas is from the Cooper Basin which historically supplied the southern domestic market. These purchases are reducing the volume of gas available to the domestic market and disrupting gas flows in the southern states. [Emphasis added.] 9. Given these facts, a reader of the ACCC Inquiry report would be misled if, on reviewing Table 6.2, they concluded that lowering transport costs would ameliorate the price rises experienced in southern states due to net demand from LNG exporters. Quite the opposite is true, lowering transport costs would exacerbate price rises in southern states driven by high net demand from LNG exporters. 1.2 Conclusions unaltered by market power of GBJV (to the extent it exists) 10. A reader of the ACCC Inquiry report may take away the impression that this fundamental conclusion of standard economic analysis is somehow negated by virtue of the market power that the ACCC alleges is being wielded by the largest southern gas producer, the Gippsland Basin Joint Venture (GBJV). 2 The gas users in these states are becoming overly dependent on the jointly marketed GBJV gas. If their alternative to dealing with the GBJV is to transport gas from Queensland, southern users may have to pay considerably more for gas than they are otherwise likely to pay in a competitive market. This is exacerbated by the high cost of transportation. [Emphasis added.] 11. However, references to a lack of competition between southern gas producers causing southern prices to equal Queensland prices plus transport costs (the maximum LNG 1 ACCC, Inquiry into the east coast gas market, April 2016, p ACCC, Inquiry into the east coast gas market, April 2016, p

7 netback price) are never explained in detail or in the context of a formal economic model. We develop a formal economic model in this report and find that: There are strong theoretical reasons to be sceptical about the ability of southern gas producers (acting in concert or GBJV acting unilaterally) to raise the price of gas up to the maximum LNG netback price in circumstances; The evidence reported in the ACCC inquiry suggests that this has not occurred. 12. In relation to the first point, price manipulation would require either a cartel of southern producers agreeing to restrict supply or GBJV significantly restricting its own supply at great cost to itself. In relation to the second point, there is no evidence provided of either outcome and, indeed, the ACCC inquiry states that GBJV sales are at record levels. Moreover, the fact that we are seeing gas flows from south to north, as the ACCC Inquiry itself reports, demonstrates that southern producers are not wielding market power to raise southern prices above Queensland prices It follows that the ACCC cannot simply allude to a lack of competition between producers as a reason to focus on the higher of the two southern state LNG netback prices. Given gas flows north, the lower of the two netback prices is relevant and in that scenario high transport costs actually lower wholesale gas prices in southern states. 1.3 No compelling evidence that regulation would actually materially reduce transport costs 14. The ACCC does not present any compelling evidence that regulation would actually reduce transport costs. The ACCC appears to base its conclusion largely on the fact: On two pipelines that have already recovered their construction costs, pipeline charges were per cent higher than a charge based solely on the cost of recovering the forward looking cost of operating and maintaining the pipeline. 15. In our view, there is no reasonable basis upon which a regulator would deny any future return on an asset when that asset is first subject to regulation (i.e., set the compensation to owners as if the asset at zero value (as if the owners, in fact, owned nothing of value)). 16. If the ACCC did seek to impose regulation in this manner then it is likely that long run gas transport costs would rise (not fall). This is because such a regulatory stance will discourage new investments in pipelines (be they regulated or not). (As thought 3 No retailer/customer with load in Queensland would buy gas in southern states at the Queensland price plus transport cost and, on top of this, incur transport costs back to Queensland. This would be irrational given that they could simply buy at the Queensland price (saving two times transport costs). 3

8 experiment, imagine the impact on residential construction if investors perceived that once a regulator had determined initial investments to have been fully recovered rents could only cover property maintenance costs.) The ultimate likely impact is that pipelines become capacity constrained due to lower investment in capacity (on existing and new pipelines). In this situation, marginal transportation costs would increase to approach infinity. 17. In this regard, we note that the ACCC refers to the existence of 15-year no-coverage determination provisions for greenfields pipeline projects as a way of reducing this risk to incentives for new investment. 4 We consider that the ACCC s signalled position in the Inquiry, if actually carried out (or perceived as likely to be carried out), would eliminate any benefits whatsoever from that protection. This is because the ACCC s signalled position is that any revenues earned during the holiday can be used by the regulator to justify setting a lower regulatory asset value at the end of 15 years. This renders any regulatory holiday meaningless. In fact, as explained in our companion report, it would actually create worse incentives than if the pipeline was regulated from day one. 18. Finally, we note that the ACCC s estimate of transport costs in Table 6.2 are based on the average cost of shippers take-or-pay contracts with pipelines assuming a 100% load factor. 5 In reality, once a shipper enters into a take-or-pay capacity contract then, provided the shipper has unused capacity within the contract, their marginal cost of shipping gas is close to zero. Based on data provided to the ACCC inquiry by APA, spare capacity is the norm on the SWQP. On this basis, the actual role of transport costs in price formation in the southern states is likely to be minimal given that marginal volumes can be shipped between locations at close to zero cost under existing shipping contracts. 4 ACCC, Inquiry report, p See footnote 30 on page 35 of the ACCC Inquiry report. 4

9 2 Introduction 19. APA has asked CEG to review the economic analysis that underpins Table 6.2 in the ACCC s report Inquiry into the east coast gas market. In Table 6.2 the ACCC presents analysis that purports to show that reductions in gas pipeline transportation charges, resulting from the application of regulation, would result in equivalent reductions in prices paid by consumers in southern states. 20. This report has the following structure: Section 3 sets out a formal economic model that underpins the ACCC conclusions. This model demonstrates that the ACCC s focus on the conclusion that reducing transport costs would reduce gas prices in southern states. The opposite conclusion holds if, as has been the case, gas has been flowing north from southern states into Queensland; Section 4 asks the question as to whether the existence of market power by GBJV alters this conclusion (as it appears the ACCC may be assuming)? We conclude that the conclusion holds independent of market power held by GBJV and we also raise theoretical reasons to be sceptical about the existence to an incentive/ability of GBJV to raise southern gas prices above competitive levels; Section 5 notes that much of the evidence the ACCC inquiry reports suggests that that GBJV has not restricted supply in the way it would have to raise southern gas prices above competitive levels; Section 6 provides a discussion of why the ACCC s reliance on a liquid Queensland gas market at the LNG netback price is unlikely to be true in practice; Section 7 provides a discussion of the ACCC s assumption that short term trading (STTM) markets are liquid markets. We are instructed that this assumption is wrong and section 7 steps through the implications of this for the ACCC s analysis. Section 8 discusses why the ACCC s assumption that regulation will reduce transport costs is not well founded - either at the level of average costs or, the more relevant for economic consequences, marginal cost. 21. I have read the Guidelines for Expert Witnesses in Proceedings of the Federal Court of Australia and confirm that I have made all inquiries that I believe are desirable and appropriate and no matters of significance that I regard as relevant have, to the best of my knowledge, been withheld. Dr Tom Hird 5

10 3 The ACCC s economic model 3.1 ACCC s assumption that Queensland gas prices ± transport costs determine range for southern prices 22. The ACCC describes a market for gas in which there is perfectly elastic demand for gas in Queensland. 6 This assumption is motivated by the fact that the Queensland gas market is connected to the global energy market via LNG exports. It is assumed, that gas can be diverted to the LNG export market as soon as prices in southern states (plus transport costs to Queensland) fall below the Queensland gas price (which is itself assumed to be determined by global energy markets). 23. The ACCC describes this as the sellers alternative, meaning that southern gas producers always have the alternative of selling gas into the Queensland market and, therefore, southern prices cannot fall below the Queensland price less the sellers additional transport costs of delivering to Queensland. 24. Similarly, it is assumed that gas will be diverted from LNG exports to the southern states if prices in the southern states rise above the Queensland gas price by more than the cost of transporting gas from Queensland to the southern states. The ACCC describes this as the buyers alternative (i.e., buyers will refuse to pay than this for gas purchased from southern producers). 25. As a consequence of this assumed dynamic, prices in the southern states are bounded by the value of gas to LNG exporters (the LNG netback price) plus/minus the costs of transporting gas from/to Queensland. That is, bounded by the sellers and buyers alternatives of selling/buying to/from Queensland. 26. It follows that the impact of transport costs on prices in the southern states is ambiguous. Higher transport costs will tend to raise prices in southern states if gas is being imported from Queensland into southern states. By contrast, higher transport prices will tend to lower prices in Queensland if gas is being exported from southern states to Queensland. 6 This assumption also implies that there is a perfectly elastic supply of gas from Queensland available to southern state customers at the Queensland price plus transport costs. This is because perfectly elastic demand in Queensland implies that as soon as the price in southern states exceeds the LNG netback price Queensland LNG exporters will, in effect, divert their gas from LNG exports to southern states. 6

11 3.2 With gas flowing north, lower transport costs are likely to raise southern gas prices 27. The evidence appears to support a belief that future gas flows will, at least much of the time, tend to be from southern states north into Queensland. On this basis, it can be expected that higher transport costs will actually lower the price of gas in southern states. This is because higher transport costs will tend to discourage exports of gas from southern states to Queensland and, thereby, increase the supply of gas available in southern states. 28. That is, with gas flowing north it is the sellers alternative that is more likely to be driving southern prices and the sellers alternative is lower the higher is the sellers transport costs to Queensland. This outcome is illustrated in Figure 1 below which provides a graphical supply and demand analysis. Figure 1: Supply and demand scenario with northern flows 29. In Figure 1 the southern gas market would, absent interconnection with Queensland, be in equilibrium at the intersection of the supply curve for southern producers (reflecting their marginal costs of supply) and the demand curve for southern consumers. 30. As drawn, this point of intersection is below the sellers alternative. Consequently, once the potential for interconnection with Queensland is introduced into the analysis the price in the southern states rises to be equal with the sellers alternative. The effect of this is that southern consumers reduce consumption relative to what it 7

12 would otherwise have been and southern producers increase production. The excess supply of gas in southern states so created (Q S Q) then flows north to Queensland. 31. This example clearly illustrates how higher northbound transport costs reduce southern prices. 32. It follows that, if one is attempting to analyse the impact of a change in transport costs on southern state gas prices it is important to understand whether gas flows are likely to be northward or southern. If the former then lowering transport costs will, other things equal, raise southern gas prices. 33. In this regard we note the ACCC s statement that significant investment has been made in order to increase the potential for southern gas to flow to Queensland. 7 In total, these recent investments are estimated to have cost $900 million, with over 50 per cent of that investment occurring to enable more gas from Victoria to flow north into New South Wales and up to Queensland. Of the projects listed, the expansion of the export capacity of the DTS has involved the most significant investment, with $260 million reportedly being spent to expand the export capacity for various shippers over the last 3.5 years. 34. Making such significant investments suggests that market participants believe that gas will tend to flow north from the southern states a meaningful percentage of the time. The ACCC explicitly discusses a change in the nature of gas flows from north to south historically being reversed in recent times. 7 ACCC, Enquiry into the east coast gas market, p

13 Figure 2: Excerpt from section of ACCC enquiry report Emphasis added. 35. We also note that the AEMC Gas Bulletin Board Shipper 8 list has only Santos, Origin, AGL Wholesale Gas and GLNG Operations as shippers with contracted capacity on the SWQP. Notably, the GBJV partners are not listed suggesting that the GBJV partners are selling their gas in southern locations (typically at the well-head) and, to the extent that GBJV gas reaches Queensland it is because third party shippers are transporting it in order to sell it at a higher price. 36. Elsewhere, the ACCC refers to an increased tendency for northward flows affecting competition between pipelines: accessed on 13 October ACCC, Enquiry into the east coast gas market, p

14 The increase in the volume of gas flowing north from Victoria is also resulting in changes in the competitive dynamics with competition emerging between: the EGP and MSP via the DTS for deliveries to Sydney and Canberra the western (SEA Gas/MAPS), central (DTS/MSP) and eastern (EGP/MSP) routes for deliveries to Moomba. 37. This is consistent with the flows shown on APA s capacity trading website access on 6 October. Figure 3: Capacitytrading.apa.com.au/gasflows.aspx (6/10/16) 38. It follows that a reasonable presumption is that lowering transport costs will tend to raise southern state gas prices, or, at least, will do so in reasonably common market circumstances. 10

15 3.3 Notwithstanding northern flows, the ACCC focuses on the buyer s alternative due to perceived lack of southern competition 39. Given the facts outlined above, one might reasonably expect that the ACCC, when analysing the impact of lower transport costs on southern gas prices, would give equal, if not more, weight to the potential for this to raise southern gas prices. However, notwithstanding the economic logic of its theoretical framework, the ACCC gas inquiry report tends to focus on the potential for low transport costs to lower gas prices in southern states. 40. The ACCC s focus on scenarios where high transport costs raise southern prices appears to be based on a belief that there is not sufficient competition between gas suppliers in southern states. On this basis the ACCC appears to believe that, even if gas is flowing north into Queensland, southern customers will be charged a price that is equal to the buyers alternative (Queensland price plus southbound transportation costs). 41. Such an outcome is not possible in a competitive gas market. In a competitive southern gas market, gas will only flow north if the price in the south is lower than the Queensland price (and, indeed, lower by more than the costs of transporting gas to Queensland). If, in a competitive market, the price in the south was above the price in Queensland no gas would flow north. That is, gas would not flow from where prices are high to where they are low that would be profit destroying in a competitive market. 42. However, the ACCC is clearly envisaging a monopolised southern gas market. 10 As shown in chart 2.4, the cost of transportation between Wallumbilla and the user s location is creating a range of possible gas pricing outcomes in the southern states, encapsulated by the gap between the buyer and seller alternatives (capped at the buyer s maximum willingness to pay and with a floor of the marginal cost of supply). As discussed in chapter 2, the GBJV is likely to charge domestic users in the southern states a price approaching the buyer s alternative in the absence of genuine competitive constraints. (Emphasis added.) 43. The relevant reference to section 2 in justification of this view is as follows: 10 ACCC, Enquiry into the east coast gas market, p

16 The competitive dynamics in the southern states are deteriorating considerably. In this environment, domestic users and retailers in the southern states are becoming highly reliant on off-shore gas production from the Gippsland Basin. The GBJV holds a large portion of the remaining uncontracted low cost conventional gas reserves in the east coast gas market and is now a key source of gas available in the short- to medium-term. The GBJV has given evidence that for 2017 it has sold the highest volume of gas in the history of the Gippsland Basin. Until these competitive dynamics change, the GBJV will have the bulk of market share and will hold significant market power in the southern states. (Emphasis added.) 44. It appears to be on this basis that the ACCC chooses to focus primarily on a scenario where lowering transportation costs will lower prices in southern states (rather than the reverse). That is, the ACCC appears to be relying on the assumption that market power held by GBJV means that southern gas customers will have to pay the buyers alternative based on the cost of importing gas from Queensland in all market circumstances (even if gas is, or would typically be, flowing north into Queensland). 45. This is precisely how the ACCC introduces its analysis in Table 6.2 on page 115 of the enquiry report. That table shows a one for one reduction in the delivered price of gas in Sydney as a result of lower transportation costs (which the ACCC assumes will flow from regulation). The focus on falling prices as a result of falling transportation costs is justified on the basis that: Critically, in an environment where domestic gas users in the southern states are likely to pay a price approaching the buyer s alternative, the maximum price they may have to pay is reduced. 46. ACCC Chairman, Mr Rod Sims, is explicit about this assumption in a recent speech. 11 Gas users in the south will be forced to bargain with the Gippsland Basin Joint Venture in a market where their only alternative may be to source gas from Queensland. In this scenario, the Gippsland Basin Joint Venture will want to price up to the delivered price of this alternative. This will amount to the LNG netback price at Wallumbilla plus the cost of transport to ship it south. [Emphasis added.] 11 Mr Rod Sims, Keynote Address: South East Asia Australia Offshore & Onshore Conference, 15 September

17 4 ACCC economic model with GBJV market power 47. The ACCC does not provide a formal economic analysis of how the GBJV can force the price in southern states to be equal to the buyers alternative even when this would not be the case without the GBJV exercising market power. This section provides such a formal analysis and, in doing so, establishes the necessary conditions for this to be the case. 48. We conclude in this section that these conditions are unlikely to hold in general and, in section 5, that the available evidence suggests that they do not hold in fact. Therefore, we conclude that the ACCC s focus is misplaced. Lowering transport costs is likely, if anything, to raise southern gas prices charged by producers. 49. This does not imply that we consider that gas transport prices should be set on the basis of targeting gas supply prices in southern states (or elsewhere). In our view, this is a largely irrelevant consideration to good policy in terms of the gas transmission sector. However, it does appear to be a focus of the ACCC inquiry and subsequent media commentary by ACCC officials. It is purely as a correction to the economic reasoning underpinning those positions that this section targeted. 4.1 ACCC model with market power 50. The ACCC s (implicit) model can be described graphically using the simplified supply and demand framework set out in Figure 1 above. Figure 4 is the same as Figure 1, however, in Figure 4 southern gas producers restrict supply of southern gas forcing southern prices up the southern demand curve until they are equal to the buyers alternative of transporting gas from Queensland. 51. The necessary restriction in supply (relative to competitive southern gas output) is Q S R in Figure 4. This restricts overall output to Q S S at which point the price that can be charged is equal to the buyers alternative of importing gas from Queensland. 13

18 Figure 4: Simplified ACCC model of gas market 52. Under this strategy, southern gas producers gain additional revenues from the higher prices (represented by the area ABCD in Figure 4). However, southern producers sacrifice profits on sales that they would otherwise have made (Q S R) - with the minimum value 12 of reduced profits represented by the area of the triangle DEG. This triangle represents the difference between the price at which the restricted gas could have been sold (sellers alternative) and the marginal cost of production (including any opportunity cost of production today reducing potential future production). 53. As drawn, the area ABCD is clearly larger than DEG and, therefore, this strategy is overall profitable for the southern producers. However, as explained in section 7, the difference between sellers and buyers alternatives will reflect marginal transportation costs (not average transportation costs). Therefore, it is not obvious that this gap will be very large at all (making the strategy less likely to be profitable). 54. In any event, the difficulty with such a strategy, even if it were to be profitable in theory, is coordination between producers. If supply was restricted to Q S S then the prices that southern producers would be able to earn from selling more to southern customers would be above their marginal cost by the amount represented by the distance AE in Figure This is the minimum value because it assumes that all restrictions in supply are sourced from the highest cost producers. However, in reality the highest cost producers will not be willing to shoulder all of the responsibility for restricting supply. Consequently, the other cartel members would need to compensate them with side payments or all producers would have to restrict supply (even low cost producers) which would make the foregone profits higher than the triangle DEG. 14

19 4.2 Cartelisation vs unilateral action by GBJV 55. The gap between price and cost creates an incentive for suppliers to increase supply (i.e., to compete). If all southern gas producers are to share in the restriction of supply then they must enter into a cartel arrangement that specifies each member s maximum output. Moreover, once this agreement is made it must be enforceable. That is, there must be a method by which other members of the cartel can observe such cheating and punish the relevant gas producer. 56. With a homogenous product, if a cartel member cheats the only mechanism for punishment is typically an increase in supply by other members (pushing down the market price for all concerned). This makes punishment costly and, if the cheating cartel member has entered into a long term supply agreement, that form of punishment will have little effect on them. In addition, the large number of non- GBJV producers and their disparate sizes would make the coordination of the cartel very difficult. 57. The ACCC does not express any concern, at least explicitly, about cartel conduct amongst southern producers. Therefore, we can assume that the ACCC s primary mechanism for the restriction of supply is unilateral action by GBJV. Such a strategy is potentially profitable for GBJV if its sales represent a large enough proportion of total southern sales and if the price increase it can initiate is large (i.e., if the Buyers alternative price is sufficiently above the sellers alternative again see section 7 for why this may be unlikely). 58. While GBJV is a large producer in southern states, it is far from a monopolist. According to Chart 2.3 on page 50 of the ACCC enquiry report the GBJV supplied 55% of 2015 gas production in the east coast excluding Queensland. This still leaves 45% of production in the hands of other suppliers. Moreover, given that some of this production was exported to Queensland, non-gbjv production as a percentage of total sales in southern states is even larger. 59. Consequently, the GBJV unilaterally restricting its supply of gas to southern customers would, assuming GBJV is a low cost producer, be an expensive exercise in terms of the foregone profits for GBJV of the restricted supply. This scenario is illustrated in Figure 5 below which shows: GBJV restricting its supply of gas by just enough such that total southern supply (including supply from of non-gbjv southern producers) is at the point where the prices in the southern states are just below the buyers alternative. This is illustrated by the intersection of the vertical dotted line ( Supply in the southern states after GBJV unilateral restriction ) with both: the southern state demand curve; and the buyers alternative ( P Q+ Transport costs from Q to South ). 15

20 Figure 5: GBJV restricts supply to southern states 60. If implemented perfectly, GBJV will raise its profits by an amount equal to the area of the yellow rectangle (equal to the increment to the price of southern sales multiplied by GBJV s quantity of southern sales post supply restriction). However, GBJV gives up revenues with a value equal to the area of the pink rectangle (equal to the restricted supply (Q S R) multiplied by the price that would have been received for those sales if they weren t restricted (the sellers alternative)). 61. As drawn, the lost revenue is clearly larger than the revenue gain. Assuming GBJV has low marginal costs of production 13 the same will be true of profits (i.e., lost profits on lost sales will exceed profits gains on the higher priced residual sales). Of course, there are potential circumstances in which the profit gain could exceed the profit loss (e.g., if the southern demand curve was steeper and/or the gap between sellers and buyers alternative larger. 62. That said, other factors, not modelled in the above static analysis, would suggest that GBJV withholding supply is less likely to be profitable. Critically, were GBJV to restrict supply and raise prices in this manner, then most of the benefits flow to its 13 Note that in the context of GBJV withholding supply the triangle EDF no longer represents the lost profits. This is because the triangle EDF represents lost profits for the industry if the highest cost producers are the ones who reduce output. It is very unlikely that GBJV would be the only contributor to the industry supply curve in the region denoted by Q S R. At least some of GBJV s supply withheld will have a cost on the industry supply curve in the region Q S S. That is, GBJV will have to withhold some relatively low cost production if it were to unilaterally withhold Q S R. In fact, given that GBJV is the largest producer the natural assumption would be that GBJV has the lowest marginal supply cost of all the producers (i.e., that is why it has expanded its output by more than the other producers). 16

21 southern competitors who do not have to restrict their own sales to achieve the heightened prices. As drawn, we have assumed that the non-gbjv producers do not increase output as a result of the higher prices. That is, we have assumed that they maintain output at 45% of the total output pre GBJV restriction in supply. 63. This is a very conservative assumption. If non-gbjv producers did increase production in response to higher prices then GBJV would need to restrict supply by even more in order to have the same impact on southern prices. In fact, if non-gbjv suppliers simply expanded along a supply curve with the same slope as in Figure 5 then, even if GBJV withdrew 100% of its supply, then the southern price would not rise all the way to the buyers alternative. 64. This is illustrated in Figure 6 which is the same as Figure 5 except, instead of non- GBJV supply remaining constant as prices rise, non-gbjv producers increase output along a supply curve with the same slope as the industry supply curve. Figure 6: GBJV restricts supply to southern states 65. It can be seen that, as drawn, even if GBJV withdrew 100% of its sales, non-gbjv producers would expand by a sufficient amount to keep the southern price of gas below the buyers alternative. Clearly this is not a profit maximising strategy for GBJV. 66. We also note that there are further technical problems with the ACCC s LNG netback framework that, when taken into consideration, would make a supply withdrawal strategy by GBJV less likely to be profitable. We discuss these in sections 6 and 8 and Appendix B. 17

22 67. Of course, Figure 6 is, along with all of the other similar figures, purely illustrative. We have not attempted to actually estimate the shape of the supply and demand curves involved. It may be that non-gbjv suppliers face a much steeper increase in costs as they increase output, at least in the short run. However, the key point is that the ACCC needs to perform this type of analysis, using real world estimates of costs and demand, before reaching a conclusion that GBJV has an incentive and ability to raise price to the buyers alternative. Absent such analysis, the ACCC s statements that GBJV has an ability and incentive to set southern prices at the buyers alternative is merely speculation. Moreover, it is speculation that is inconsistent with the available evidence which we survey in section In summary, any unilateral restriction of supply by GBJV to southern customers would come at a cost to GBJV. It is far from obvious that it could be profit enhancing. 18

23 5 Evidence does not support ACCC contention 69. We conclude in this section that the available evidence suggests that southern gas prices are not being set at the buyers alternative. Consequently, it is not correct to assume that lower transport costs will lower gas prices in southern states. The opposite is more likely to be the case. 5.1 Gas flow and GBJV output data does not support ACCC concern 70. The fact that we see gas flowing from south to north (see section 3.2) is evidence that is inconsistent with the ACCC s contention that southern prices are being set above the price of gas in Queensland (i.e, at the buyers alternative). If that was the case then it would imply that shippers/retailers were purchasing higher priced gas in southern states for the purpose of transporting it to Queensland (incurring additional transport costs in the process) and selling it at a lower price in Queensland. That is, shippers/retailers would have to be making a loss (equal to 2 times transport costs) on all southern gas transported to Queensland. 71. In fact, if GBJV was exercising market power (with the effect of setting prices in southern states equal to the buyers alternative) then the effect of this would be that there would be approximately zero gas flowing between Queensland and southern states (in either direction). After all, that is the purpose of the strategy the ACCC alleges GBJV is undertaking in effect to restrict supply until prices in southern states are equal to prices in Queensland after adjusting for transport costs. If GBJV achieves this then the demand for transport to/from Queensland would largely disappear. 72. In addition, we note that the ACCC itself states that the GBJV has contracted record sales for The GBJV has given evidence that for 2017 it has sold the highest volume of gas in the history of the Gippsland Basin 73. On its face, this appears inconsistent with GBJV withholding supply in order to generate higher prices. 14 ACCC, Inquiry in the east coast gas market, 2016, p

24 5.2 No explicit model of GBJV conduct provided by the ACCC 74. The ACCC s view of exactly how GBJV is exercising market power is not provided in any formal analytical sense. However, the following statement is notable: The gas users in these states are becoming overly dependent on the jointly marketed GBJV gas. If their alternative to dealing with the GBJV is to transport gas from Queensland, southern users may have to pay considerably more for gas than they are otherwise likely to pay in a competitive market. This is exacerbated by the high cost of transportation. Increasing the level and diversity of supply, located close to southern demand centres, will improve the competitive dynamics in the south and is likely to lead to better pricing outcomes for domestic users. [Emphasis added.] 75. This statement suggests that: were there competition in southern states prices would be set at the sellers alternative; but that the lack of a competitive market is causing prices to be set at the buyers alternative. 76. In section 4 we have provided an analytical model and a description of conduct by GBJV (or a cartel of southern producers) that could be consistent with both of these propositions. That model is internally consistent and a number of implications flow from the model. These include that: GBJV cannot push prices up from competitive levels without sacrificing sales (and some profits on the sacrificed sales); GBJV is not a pure monopoly supplier in the southern states and this materially reduces the benefit/cost ratio to it of such an action because: The benefits of higher prices flow mostly to GBJV s competitors while the costs in terms of lost profits on restricted sales are 100% borne by GBJV; The benefits of higher prices are capped by competition from Queensland. 77. Based on this analysis it is far from obvious that GBJV has any incentive to restrict supply with a view to increasing southern gas prices up to the buyers alternative. This scepticism is strengthened when one takes into account the long term impact of such a strategy due to the promotion of rival southern producers investments in additional capacity. 78. By contrast, the ACCC provides no such transparent model of the market. The ACCC appears to be simply assuming that because GBJV is large it has market power and this market power can, and will, be costlessly used to raise southern prices. 20

25 79. This is not, in our view, a sound conclusion based on robust economic analysis. In this regard, we note that it is not enough to point to shortages of supply in southern states as a justification for GBJV being able to charge the buyers alternative. If naturally occurring shortages in supply create this opportunity then no market power is being exercised. In order to conclude that market power being exercised, GBJV must be creating that shortage in supply by artificially restricting its own supply in which case GBJV must be sacrificing profits on restricted sales. 80. Moreover, if this strategy was actually being implemented we would not expect, as set out in section 5, to see: gas flows from southern states to Queensland; GBJV having record sales in

26 6 Assumed link between LNG netback and domestic prices 81. The ACCC assumes that that the presence of LNG export operations in Queensland will create an elastic (i.e., very price sensitive) supply of gas: from Queensland to southern states at a price equal to the LNG netback price plus transport costs; to Queensland from southern states at a price equal to the LNG netback price plus transport costs. 82. That is, the ACCC assumes that gas can be diverted from/to LNG export in large quantities as soon as domestic prices depart from international energy prices (less the costs of converting domestic gas to export LNG). 83. This, in effect, creates an assumed dead zone for southern prices where there is no competition from Queensland gas producers. This dead zone is the difference between the buyers alternative and the sellers alternative depicted in Figure 1, Figure 4 and Figure 5. Within this dead zone, the price of gas sold to southern customers will be set purely by competition between southern gas producers without any constraint imposed by Queensland (and Northern Territory) gas producers and/or consumers. 84. In our view, this assumption not accurate. Our expectation is that, consistent with most such capital intensive projects, providers along the LNG supply chain will have built little excess capacity into their operations (i.e., above and beyond that paid for by customers under take-or-pay style contracts). Therefore, the ability of LNG exporters to respond to low domestic gas prices by exporting more LNG will be limited by the capacity of the elements of the LNG export chain (including liquefaction facilities but also carrier capacity and terminal capacity). 85. Consistent with this, the ability of LNG exporters to respond to higher domestic gas prices will be limited by the need to fulfil contractual obligations (under take or pay contracts) with their customers. At very high domestic gas prices (relative to international energy prices) there may be some capacity to renegotiate with customers to take less LNG (allowing LNG exporters to divert gas to the domestic market). However, this would only be done, if at all, if the domestic prices in Australia justified leaving expensive LNG capacity unutilised. There will be a wide range of price differences (between Queensland gas and international energy prices) where this is not the case. 86. These issues are discussed in more detail in Appendix A. However, the important conclusion for analysis of domestic competition is that, in reality, the dead zone assumed by the ACCC will not exist (or, at least, will typically not exist). That is, prices 22

27 in Queensland and southern states will typically be linked by competition between suppliers in all states for customers in all states. 87. By way of practical example, consider a scenario where domestic (including Queensland) gas prices are below the LNG netback price (e.g., because the international oil price is high). Let LNG exporters be operating at full capacity such that LNG exporters are simultaneously: unable to absorb additional domestic gas; and unprepared to divert any export gas for domestic sales. 88. Also assume that gas prices in southern states are lower than those in Queensland such that gas is being transported north to equalise those prices (after transport costs). This is the scenario under which the ACCC believes GBJV will have an incentive to exercise market power and increase southern gas prices up to the buyers alternative. 89. However, with LNG exports at full capacity due to high international oil prices the LNG netback price will be above the Queensland price. Gas producers would like to produce more and sell it to LNG exporters at the LNG netback price but capacity constraints prevent this. Queensland and southern gas prices will still be linked by transport costs but the Queensland price will no longer be fixed by international energy prices. Now, southern prices and Queensland prices will tend to move together. An increase in southern prices cannot be achieved without a similar increase in Queensland prices and vice versa. 90. Now consider a strategy under which GBJV restricts its supply in an attempt to raise the southern gas price it receives. In the ACCC model this reduction in GBJV supply has a stronger impact on southern prices because there is no demand/supply response from Queensland customers/producers (who are assumed to buy and sell as much gas as they wish at the LNG netback price). However, if capacity constraints at LNG exporters exist then a reduction in GBJV supply will tend to cause an increase in both southern and Queensland gas prices. Consequently, there will be a supply response from a larger set of producers (i.e., including Queensland producers) and a demand response from a larger set of customers (i.e., including Queensland customers). 91. In the latter scenario GBJV must now influence prices in the entire east coast (not just the southern states). This means it will have to restrict supply by more for the same unit increase in prices (because there are more consumers to respond by reducing demand and more suppliers to respond by increasing supply). This makes such a strategy less likely to be profitable. 23

28 7 The relevant measure of transport costs is shippers marginal (not average) costs 7.1 Shippers marginal transport costs do not equal their average tariff 92. In Table 6.2 of the ACCC s report the ACCC estimates the impact of a 10% to 50% reduction in transport costs. However, the ACCC s estimate of transport costs are based on the average costs of shippers take or pay contracts with pipelines assuming a 100% load factor This is, very likely, a material overestimate of the marginal transportation costs faced by shippers in the short term. This is because large shippers already have what amounts to zero (or low) marginal cost transport tariffs up to their contracted capacity. Any shipper (or combination of shippers) with spare capacity on routes between locations would rationally use that to arbitrage between two different liquid markets in those locations (assuming such markets were to exist). 94. Spare capacity is the norm on the SWQP is illustrated in the following two charts using data that was supplied to the ACCC Inquiry. 15 See footnote 30 on page 35 of the ACCC Inquiry report. 24

29 Figure 7: SWQP western haul firm allocation vs firm MDQ Source: APA 25

30 Figure 8: SWQP eastern haul firm allocation vs firm MDQ Source: APA 95. It can be seen that there is typically significant excess capacity within the allocations to existing shippers. This means that the relevant estimate of transport costs in the ACCC s analysis is much lower than the average costs that is assumed in Table Were the ACCC to regulate gas pipelines (such as the SWQP) and the result of this regulation was to reduce average tariffs it still would not necessarily have any impact on the marginal costs of transport faced by shippers which are already well below the average tariff that they pay. Given shippers will rationally respond to marginal incentives it is not obvious that such a reduction in average transport costs will have any impact on gas prices able to be charged by producers. 7.2 Regulation will not necessarily reduce transport costs either marginal or average 97. The ACCC proceeds on the assumption that regulation will reduce average transport tariffs. However, it has no basis for making that conclusion other than: ACCCC, Inquiry report, p

31 One pipeline estimated that it was earning 70 per cent more in revenue than it believes it would if it was regulated, which would imply approximately a 40 per cent reduction in prices if the firm moved to its estimate of revenue under regulation. On two pipelines that have already recovered their construction costs, pipeline charges were per cent higher than a charge based solely on the cost of recovering the forward looking cost of operating and maintaining the pipeline. 98. With regards the first point it is unclear on what basis the pipeline made this 70% estimate and, in any event, what is its relevance? What a firm estimates that a regulator might do does not form a reasonable basis for a regulator determining what it would do. (For example, the 70% estimate may reflect a view that a regulator would likely undercompensate them for their true costs as indeed the second point suggests is the ACCC s intention.) 99. In relation to the second point, there is, in our view, no reasonable basis upon which a regulator would deny any future return on an asset when that asset is first subject to regulation (i.e., set the compensation to owners as if the asset had zero value (as if they, in fact, owned nothing at all)) If the ACCC did seek to impose regulation in this manner then it is likely that long run gas transport costs would rise (not fall). This is because such a regulatory stance will discourage new investments in pipelines (be they regulated or not). (As thought experiment, imagine the impact on residential construction if investors perceived that once a regulator had determined initial investments to have been fully recovered rents could only cover property maintenance costs.) The ultimate likely impact is that pipelines become capacity constrained due to lower investment in capacity (on existing and new pipelines). In this situation, marginal transportation costs increase to approach infinity In this regard, we note that the ACCC refers to the existence of 15-year no-coverage determination provisions for greenfields pipeline projects as a way of reducing this risk to incentives for new investment. 17 We consider that the ACCC s signalled position in the Inquiry, if actually carried out (or perceived as likely to be carried out), would eliminate any benefits whatsoever from that protection This is because the ACCC s signalled position is that, when it comes to regulate a new pipeline, even if it is 15 years after its initial operation, the ACCC will be prepared to set the asset value based on an estimate of already recovered construction costs (accounting for the time value of money). This renders any regulatory holiday meaningless because the ACCC is able to use whatever revenues are earned in that holiday (plus a return on those revenues) to reduce the asset value for which it will 17 ACCC, Inquiry report, p