Methodology to approve maximum prices for Piped Gas. Consultation Document. 21 October 2010

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1 Methodology to approve maximum prices for Piped Gas Consultation Document 21 October

2 1. Introduction Purpose The purpose of this consultation document is to provide a basis for discussion from which the National Energy Regulator of South Africa (NERSA) will facilitate engagement on a methodology that NERSA will utilise in the approval of maximum piped gas prices as required by the Gas Act, This document has therefore been prepared for stakeholder consultation based on research conducted by NERSA. NERSA welcomes contributions on the best approach to be adopted in order to further the objectives sought by the Gas Act in respect to approving maximum prices for piped gas. Structure of the Paper This document is structured as follows: The overall regulatory process and specifically the consultation process An overview of the piped gas industry NERSA's role and objectives in the regulation of piped gas Key considerations in the regulation of piped gas prices Determining the maximum price for gas energy Determining the tariff for gas transportation Determining the tariff / margin of gas trading Preferred methodology for specifying maximum price Implications Way forward 2

3 2. Consultation Process Consultation Schedule Activities (a) Publication of the draft methodology to approve maximum prices for Gas Date 20 0ctober 2010 (b) Stakeholder s consultation workshops: Gauteng Swan Lake Lodge 98 Erasmus Avenue 26 October 2010 Centurion Durban Protea Hotel Edward 149 O.R Tambo Marine Parade 02 November 2010 Durban (c) Public Hearing 03 Decmeber 2010 (d) Effective date for implementation of the methodology 01 April

4 3. Overview of the Piped Gas Industry To give a context and framework for describing the pricing of piped gas in South Africa a simple supply chain model has been adopted. The basic supply chain consists of a production facility where (theoretically) gas enters a gas storage facility from which it feeds a transmission pipeline network (that is, one operating at pressures greater than 15 bar), which delivers gas to either transmission linked customers or a distribution pipeline network (that is, one operating at pressures less than 15 bar but greater than 2 bar), from which customers may be supplied or which in turn may deliver gas to a reticulation pipeline network (operating at pressures less than 2 bar), from which customers are supplied. In terms of the ownership and operation of the infrastructure: The storage facility is owned and operated by a Storage Company, which charges the Storage tariff for the storage services it provides. The Storage Company does not own the gas being stored. The transmission pipeline is owned and operated by a Company. The Company charges a Tariff for the transport services it provides. The distribution pipeline is owned and operated by a Distribution Company. The Distribution Company charges a Distribution Tariff for the transport services it provides. The reticulation pipeline is owned and operated by a Reticulation Company. The Reticulation Company charges a Reticulation Tariff for the transport services it provides. In terms of the ownership of the gas: A Trader is responsible for purchasing the gas at the point of production, for which it pays the Wellhead Price of the gas. The Trader pays the Storage Company (if applicable) the Storage Tariff to store its gas, the Company the Tariff to transport that gas, and sells the gas at the point where the gas enters the distribution network. When selling gas, the Trader recovers its costs and charges a Trading Tariff for the trading services that it provides in procuring the gas and its delivery. A Distribution trader (Distributor) is responsible for purchasing the gas from the Trader, paying the Distribution Company the Distribution Tariff to transport that gas, and sells the gas at the point where the gas enters the reticulation network. When selling gas, the Distributor recovers its costs and charges a Distribution Trading Tariff for the trading services that it provides in procuring the gas and its delivery. A Reticulation Trader (Reticulator) is responsible for purchasing the gas from the Distributor, paying the Reticulation Company the Reticulation Tariff to transport that gas, and sells the gas to the customers. When selling gas, the Reticulator recovers 4

5 its costs and charges a Reticulation Trading Tariff for the trading services that it provides in procuring the gas and its delivery. This simple model is illustrated in the following diagram: Upstream Industry PIPED GAS INDUSTRY Tx Receipt Point Distribution Reticulation Unlicencedand Unregulated Licenced only Customers Suppliers Gas Levies Storage Tariff Contract (GSA) Actual Price Trader Commercial and Industrial Licencedand Regulated Trading Tariff Tx Tariff Gas Price Trader s Actual Price Distributors Other Consumers (mostly large) Trading Tariff Dx Tariff Distributor s Actual Price Reticulators Other Consumers Trading Tariff Rx Tariff Reticulator s Actual Price Other Consumers Note: Red identifies tariffs regulated by NERSA Customer Size Large Residential (mostly small) Small Questions 3.1 Does the value chain for the piped gas industry involve any activities in addition to gas production, gas storage, transmission, transmission trading, distribution, distribution trading, reticulation, and reticulation trading that should be taken into account when considering the maximum price of piped gas? 3.2 Is competition inadequate along the whole value chain? 5

6 4. NERSA s Role and Objectives in Regulating Gas Prices NERSA is established pursuant to section 3 of the National Energy Regulator Act, 2004 which in terms of section 4 requires it to undertake the functions of the Gas Regulator as set out in section 4 of the Gas Act. Section 4 of the Gas Act, 2001 (the Act) establishes that NERSA: must, as appropriate, in accordance with this Act: (g) regulate prices in terms of section 21(1)(p) in the prescribed manner; (h) monitor and approve, and if necessary regulate, transmission and storage tariffs and take appropriate action when necessary to ensure that they are applied in a non discriminatory manner as contemplated in section 22 [Gas Act 4(g) & (h)] Section 21 of the Act provides that NERSA: may impose licence conditions within the following framework of requirements and limitations: (p) maximum prices for distributors, reticulators and all classes of consumers must be approved by the Gas Regulator where there is inadequate competition as contemplated in Chapters 2 and 3 of the Competition Act, 1998 (Act No. 89 of 1998); [Gas Act 21(1)(p)]. From these legislative provisions it may be observed that NERSA s mandate in respect of gas pricing is, inter alia, to approve maximum prices for different classes of consumers. This is depicted in the diagram below: Upstream Industry PIPED GAS INDUSTRY Suppliers Tx Receipt Point Distribution Reticulation Max Price 1* Max Price 2* Trader Customers Large Small Contract Actual Price Commercial and Industrial Residential Distributors Other Consumers (mostly large) Reticulators Other Consumers Other Consumers (mostly small) Consumer Classes Distributors Reticulators Class 6 (> 4 PJ pa) Class 5 (400 TJ to 4 PJ pa) Class 4 (40 to 400 TJ pa) Class 3 (4 to 40 TJ pa) Class 2 (400 GJ to 4 TJ pa) Class 1 (< 400 GJ pa) Trader s Actual Price Distributor s Actual Price Reticulator s Actual Price Approval Process: Upstream No Approval of Actual Price (based on GSA Contract) Distribution Reticulation Actual** Trader Price less than Max Price 1* Actual** Distribution Price less than Max Price 2* No Approval of Actual Price (as Reticulators are not required to be licenced) * NERSA s efficient price benchmark ** Actual refers to the licensee s proposed prices 6

7 Regulation of Gas Prices Section 4(g) of the Act outlines NERSA s functions to include the regulation of piped gas prices which must be in the prescribed manner and in terms of section 21(1)(p) of the Act. In line with this obligation, NERSA when imposing licence conditions to its licensees must approve maximum prices for piped gas for: i. distributors; ii. reticulators; and iii. all classes of consumers 1 However the Act explicitly excludes Reticulators (in their capacity as suppliers) from the requirement to hold a licence: a person engaged in an activity referred to in Schedule 1 is not required to apply for or to hold a licence [Gas Act 15(2)] and, Schedule 1 includes: Gas reticulation and any trading activity incidental thereto. As NERSA s mandate to approve maximum prices is established through its ability to impose licence conditions, customers that are served by reticulators will not be subject to maximum prices. It should also be noted that NERSA s responsibility to approve maximum prices requires inadequate competition (as contemplated by chapters 2 and 3 of the Competition Act, 1998). It is important to note that the maximum price of piped gas, is a composite of different charges and tariffs accruing up to the point of sale. To this end, NERSA is mandated in terms of section 4(h) of the Gas Act to monitor and approve, and if necessary regulate, transmission and storage tariffs and... ensure that they are applied in a non discriminatory manner. The role of NERSA is further enunciated in the Gas Act: Piped Gas Regulations, 2007, where pursuant to regulation 4: The Gas Regulator must, when approving the maximum prices : (a) be objective i.e. based on a systematic methodology applicable in a consistent and comparable basis; (b) be fair; (c) be non discriminatory; (d) be transparent; (e) be predictable; and (f) include efficiency incentives. [Piped Gas Regulations, 4(3)] 1 Some classes of consumer are served by reticulators which are not required to be licensed by NERSA. 7

8 Furthermore: Maximum prices referred to in subregulation (3) must enable the licensee to: (a) recover all efficient and prudently incurred investment and operational costs; and (b) make a profit commensurate with its risk. [Piped Gas Regulations, 4(4)]. Whilst the above principles must be dominant in the task undertaken by NERSA, the actual operational activity is provided for in regulation 4(7) where licensees are to provide NERSA with such information that will enable NERSA to determine the maximum price applicable to that licensee. Licensees are therefore required to submit maximum prices to NERSA for approval and this inevitably will require that NERSA either accept or reject these prices. Gas Industry Objectives Section 2 of the Gas Act, 2001 establishes the following objectives: (a) promote the efficient, effective, sustainable and orderly development and operation of gas transmission, storage, distribution, liquefaction and re gasification facilities and the provision of efficient, effective and sustainable gas transmission, storage, distribution, liquefaction, re gasification and trading services; (b) facilitate investment in the gas industry; (c) ensure the safe, efficient, economic and environmentally responsible transmission, distribution, storage, liquefaction and re gasification of gas; (d) promote companies in the gas industry that are owned or controlled by historically disadvantaged South Africans by means of licence conditions to enable them to become competitive; (e) ensure that gas transmission, storage, distribution, trading, liquefaction and regasification services are provided on an equitable basis and that the interests and need of all parties concerned are taken into consideration; (f) promote skills among employees in the gas industry; (g) promote employment equity in the gas industry; (h) promote development of competitive markets for gas and gas services; (i) facilitate gas trade between the Republic and other countries; and (j) promote access to gas in an affordable and safe manner. [Gas Act, 2(a) (j)]. NERSA must have regard to these objectives. 8

9 Evaluation Criteria In developing a methodology for approving maximum prices, and in the regulation of gas prices, it is important that the above principles and objectives of the Piped Gas Regulations, 2007 and the Gas Act, 2001 are satisfied. For this reason, these principles and objectives have been used in this Consultation Document as criteria for evaluating methodological options for determining the maximum price of piped gas. However, the objectives specific to BEE/EE, gas safety, and skills promotion do not provide a basis of discernable difference between the theoretical options, and hence, the evaluation pivots around the remaining criteria. The specific criteria mentioned will be taken into account in specific licence and price applications where applicable. Questions 4.1 Is it appropriate to interpret all classes of consumer in section 21(1)(p) of the Gas Act, as being limited to consumers of licensees? 4.2 Would setting maximum prices for reticulation customers serve any useful purpose given the lack of a legal mandate by NERSA to enforce them? 9

10 4.3 Aside from the principles set out in subregulation 4(3) of the Piped Gas Regulations, and the objectives set out in section 2 of the Gas Act, are there any other criteria for evaluating options for determining the maximum price of piped gas? 10

11 5. Key Considerations in the Regulation of Gas Prices From the legislative/regulatory framework it may be observed that, in respect of approving maximum prices, it is important to establish what purchasers of gas constitute classes of consumer, whether competition is inadequate, what is meant by approval, and what constitutes the gas price. Conceptual Framework The following conceptual framework of gas pricing, as envisaged by the legislation, is provided as a guide to the development of the methodology that NERSA proposes to utilise in the approval of maximum prices for piped gas. Upstream Industry PIPED GAS INDUSTRY Tx Receipt Point Distribution Reticulation Unlicencedand Unregulated Cost Components Gas Levies Storage Tariff Price GE LV S Licencedand Regulated Trading Tariff Tx Tariff Gas Price Max Price 1* TT Tx GE LV S Trading Tariff Dx Tariff Licenced only Max Price 2* TD Dx TT Tx GE LV S Trading Tariff Rx Tariff Price TR Rx TD Dx TT Tx GE LV S Key: Max Price Components TR = Reticulation Trading Tariff Rx = Reticulation Tariff (Pipes) TD = Distribution Trading Tariff Dx = Distribution Tariff (Pipes) TT = Trading Tariff Tx GE LV S = Tariff (Pipes) = Gas Energy (Molecules) = NERSA Levies = Gas Storage Tariff Trader Note: Red identifies tariffs regulated by NERSA Large Contract Actual Price Distributors Consumer Classes Distributors Customers / Actual Prices Small Commercial and Industrial Residential Other Consumers (mostly large) Reticulators Other Consumers Other Consumers (mostly small) Reticulators Class 6 (> 4 PJ pa) Class 5 (400 TJ to 4 PJ pa) Class 4 (40 to 400 TJ pa) Class 3 (4 to 40 TJ pa) Class 2 (400 GJ to 4 TJ pa) Class 1 (< 400 GJ pa) Trader s Actual Price Distributor s Actual Price Reticulator s Actual Price Approval Process: Upstream No Approval of Actual Price (based on GSA Contract) Distribution Reticulation Actual** Trader Price less than Max Price 1* Actual** Distribution Price less than Max Price 2* No Approval of Actual Price (as Reticulators are not required to be licenced) * NERSA s efficient price benchmark ** Actual refers to the licensee s proposed prices 11

12 The key points to note from this conceptual framework are: o NERSA does not regulate prices upstream of the Piped Gas Industry (i.e. for approving a maximum price for the Trader s purchases of gas 2 ); o The exception is gas storage, which is regulated by NERSA, and may be stored upstream, or (as is most common) in the transmission pipeline itself (which is excluded from the storage tariffs); o There is no effective statutory mechanism for NERSA to approve the maximum price for reticulation customers; o Maximum prices differ along the value chain as the service (or product ) increases in value; o The maximum price will, as a consequence, be a composite price, informed by several price and tariff components; and o Regulated tariff components will be treated as a pass through in the methodology for determining maximum prices. The conceptual framework is explained and amplified in the remainder of this Consultation Paper. Customer Categories and Consumer Classes In the Piped Gas Industry, transactions involving piped gas products occur at particular points along the value chain. For the purposes of this Consultation Paper, this gives rise to generic categories of customer 3 these being: Customers Distribution Customers; and Reticulation Customers 4. These customer categories are portrayed in the adjacent diagram. Upstream Industry Suppliers Customers Large Small Customer Size Tx Receipt Point PIPED GAS INDUSTRY Distribution Reticulation Distributors Other Consumers (mostly large) Reticulators Other Consumers Other Consumers (mostly small) 2 Which is typically a contracted price set out in a Gas Sale Agreement. 3 Note: The use of customer in this context is not intended to follow the definition of customer set out in the Gas Act, being a person purchasing gas, or purchasing transmission, storage or distribution or liquefaction or re gasification services. 4 The reticulation service is neither licensed nor regulated by NERSA, and neither are distribution tariffs regulated by NERSA, except to the extent that maximum prices may apply. 12

13 These customers are differentiated on the basis of service (or product ) as illustrated below: (Tx) Customers Distribution(Dx) Customers Reticulation (Rx) Customers The service/product may be described as: a particular quantity of energy delivered at a particular time at a particular location... and at a given level of quality/reliability. Tx trading Risk Return Tx Trading Costs Tx Admin Costs Tx O&M Return on Tx Capital Return of Tx Capital Dx trading Risk Return Dx Trading Costs DxAdmin Costs Dx O&M Return on Dx Capital Return of Dx Capital Tx Costs Rx trading Risk Return Rx Trading Costs Rx Admin Costs Rx O&M Return on Rx Capital Return of Rx Capital Dx Costs Tx Costs Gas Energy Cost Gas Energy Cost Gas Energy Cost The maximum price will be specific to a customer category and will depend on the nature of the piped gas service received by that customer In most markets, it is unusual for price differentials to be based on customer characteristics per se. Rather, price differences tend to be based on product or service differences (e.g. the costs of bringing the product to market). In the piped Gas Industry, prices will differ across these customer categories in recognition of the different services provided to that category. At points along the value chain where transactions occur, the aforementioned customers will be either end consumers or resellers/traders. This is recognised by s21(1)(p) of the Act which requires maximum prices to be approved for: Distributors; Reticulators; and other classes of consumer. In terms of end consumers, the Piped Gas Regulations provide an additional classification of (distribution) customers for which maximum price approval is required: 13

14 The Gas Regulator must approve maximum prices for gas for each distribution area or group of distribution areas as indicated in Annexure A for the following classes of customers: (a) Residential; and (b) commercial and industrial. [Piped Gas Regulations 4(5)].... and Annexure A of the Piped Gas Regulations, 2007 further define other classes of consumers in terms of their consumption: Class 1 Class 2 Class 3 Class 4 Class 5 Class 6 annual consumption < 400 GJ 400 GJ < annual consumption 4,000 GJ (i.e. 4 TJ) 4,000 GJ < annual consumption 40,000 GJ 40,000 GJ < annual consumption 400,000 GJ 400,000 GJ < annual consumption 4,000,000 GJ annual consumption > 4,000,000 GJ (i.e. 4 PJ) It is noted that these differing classifications provided in the regulations may give rise to some overlap in classes of end consumer. For instance, a residential consumer would typically consume less that 400 GJ, and so also constitute a Class 1 consumer... but so too may a small commercial consumer. Details of consumer classes are provided in the following diagram: Customer Categoriess Customers Distribution Customers Reticulation Customers Consumer Classes Large Distributors Distributors Customers Small Commercial and Industrial Residential Other Consumers (mostly large) Reticulators Other Consumers Other Consumers (mostly small) Reticulators Class 6 (> 4 PJ pa) Class 5 (400 TJ to 4 PJ pa) Class 4 (40 to 400 TJ pa) Class 3 (4 to 40 TJ pa) Class 2 (400 GJ to 4 TJ pa) Class 1 (< 400 GJ pa) Customer Size Definitions: Consumer Classes (horizontal) Customer Categories (vertical) The maximum price may differ between classes of end consumer to reflect differences in the cost to serve or risk profiles Within a customer category the product is the same. Arguably, the only basis for charging one consumer more than another for the product is if that consumer attracts greater/lesser cost than other consumers receiving that same product. In practice, this is an issue that primarily affects traders. For instance, particular consumers may have a higher cost to 14

15 serve, or may (through their risk profile) increase the cost of capital both of which may necessitate some differentiation in price. These characteristics, however, must be factors that any competing supplier would account for in its pricing if suppliers were in fact competing for that consumer. Generally, these characteristics apply to a class of end consumer rather than individual end consumer. It would not be practical to have a maximum price for every end consumer. Given that the costs to serve 50 very large end consumers may differ considerably from the costs to serve 10,000 residential consumers, then there are reasonable grounds for the maximum price methodology to differentiate maximum prices on the class of end consumer. This would also be consistent with regulation 4(3) of the Piped Gas Regulations, 2007 which provides for the recovery of efficient operational costs. The following diagram presents an overview of customers by customer category and end consumer class 5. Upstream Industry PIPED GAS INDUSTRY Suppliers Tx Receipt Point Customer Categories Distribution Reticulation 10 licenced transmission pipelines: 9 Sasol (c. 850 km) Gauteng Free State Mpumalanga 1 Transnet (c. 600 km) Gauteng to KwaZulu Natal 40 licenced distribution pipelines throughout: Gauteng Free State Mpumalanga KwaZulu Natal (all owned by Sasol) Reticulation pipelines owned by Egoli Gas: Gauteng (c. 1,200 km) Consumer Classes Large Distributors Distributors Customers Small Commercial and Industrial Residential (Distribution Traders: Sasol Gas, Spring Lights Gas, and Novo Energy*) Other Consumers 30 to 40 Industrial Customers connected to Sasol Tx Pipelines (approx) Reticulators (Egoli Gas) Other Consumers Sasol Gas (Industrial customers) 486 (Gauteng) 7 (Free State) 8 (Mpumalanga) Spring Lights Gas 58 (KwaZulu Natal) Other Consumers 3,000 smaller Industrial and 4,500 Residential Customers connected to Egoli Pipelines Reticulators Class 6 (> 4 PJ pa) Class 5 (400 TJ to 4 PJ pa) Class 4 (40 to 400 TJ pa) Class 3 (4 to 40 TJ pa) Class 2 (400 GJ to 4 TJ pa) Class 1 (< 400 GJ pa) Customer Size Consumer Classes (horizontal) Customer Categories (vertical) * Novo Energy is a new entrant In addition, this diagram illustrates the geographic nature of the Piped Gas Industry in South Africa. The maximum price will vary by location In addition to customer specificity, the methodology for determining the maximum price will also include a locational dimension. Inter alia, this is because gas transportation costs will differ according to the characteristics of the pipeline/network in particular locations. 6 5 Details have been sourced from public information (e.g. licence applications). 15

16 The implications for the methodology to determine maximum prices, are: Maximum prices will be differentiated by generic customer category (i.e. transmission customers, distribution customers, and reticulation customers) to reflect different services provided to those categories of customer. Maximum prices will not be differentiated on the basis of end consumer except to the extent of any differences in trader tariffs that necessarily reflect differences in the cost of serving a particular class of end consumer. Maximum prices will be differentiated by location. Adequacy of Competition Competition is possible in some parts of the Gas Industry value chain whilst other parts are natural monopolies. Put differently, some parts of the value chain for the Piped Gas Industry are more contestable than others. NERSA s mandate is to apply regulation in the absence of a competitive market. This implies NERSA should encourage competition and seek to replicate competitive market outcomes in approving maximum prices. In this regard it should be noted that: Economic efficiency is a key outcome of competitive interaction, which implies that efficiency in itself is a criterion to be applied. Economic efficiency is often considered in three dimensions: o Allocative efficiency which occurs when resources in an economy are allocated to their highest value use. It particularly relates to prices. If prices are cost reflective (in a marginal sense), then the true cost of using resources in the supply of goods/services is able to be taken into account in investment and consumption decisions. o Productive efficiency which relates to a firm s cost structure in the production of goods/services. Firms should strive for the lowest sustainable cost structure. Productive efficiency occurs when demand, for a given level of quality, is met at the lowest possible cost. o Dynamic efficiency which means maintaining allocative and productive efficiency over time. In practice, this means making investments and innovating, in a timely manner, so that costs continue to be minimised and prices over time reflect this. Over or under investment should be avoided. 6 Other factors that may affect the maximum price on a locational basis are addressed later in this Consultation Document. 16

17 In theory, competitive markets balance the interests of suppliers and consumers such that Pareto optimal outcomes occur. In other words, it is not possible to change the allocation of resources in such a way as to make someone better off without making another worse off. 7 Pareto optimality has a time dimension in the case of exhaustible/depletable resources. If the current generation assumes ownership of depletable resources, then the welfare of future generations is ignored. Achieving Pareto optimality over time requires future generations to be compensated for resource depletion 8. Pareto optimal outcomes rarely occur in practice, and most regulators are content to achieve outcomes that broadly replicate, or are consistent with, outcomes expected in competitive markets. The physical characteristics of energy markets are broadly similar throughout the world. However, the manner in which efficiency is incentivised in these markets differs considerably. In some jurisdictions, certain components of the value chain are left to compete, whilst elsewhere these same components are regulated. Of interest here is the manner in which competitive markets and regulated markets seek similar efficiency outcomes. Characteristics of Competitive Energy Markets In several jurisdictions, it is recognised that energy may be sourced from alternative suppliers, and therefore the energy itself is able to be competitively priced. In a competitive market, the resource is allocated to its highest value use (allocative efficiency), and the opportunity for arbitrage would ensure that price discrimination between customers is not sustainable. The marginal price of energy will be the same across the entire system/network unless losses vary by location (which tends to be the case with electricity more so than with gas), or binding constraints at particular locations mean that another supplier becomes the marginal supplier at that point. Competitive forward/contract markets also exist in some jurisdictions. These tend to be forward looking, based on expectations of where spot prices are likely to trend in the future (over the tenor of the contract). 7 Whether, from a social or other perspective, this constitutes the most desirable allocation of resources is a separate issue. 8 Hotelling (1931) provided a basis for inter temporal resource allocation implying a price path that either reduces demand to zero, or reaches the price of an alternative resource, by the time the resource is depleted. It is intended that rents from the depletion/consumption of the resource in the interim should be shared with future generations as compensation (including through investments in sustainable alternatives). Refer to: Hotelling H.; "The Economics of Exhaustible Resources ; Journal of Political Economy; 1931, Vol 39, p

18 In competitive retail (trading) markets, the retail (trading) margin is not regulated. To remain in business the trader can afford only to recover the efficient costs to acquire, serve, and retain customers, and to provide ex ante compensation for the risks it bears in relation to reselling and customer default. Any margin higher than the one explained would lead to entry by competitors and eventual exit by the inefficient trader. The cost to serve different retail or trading customers varies, economies of scale often exist and some customer types cost more to serve than others. The key points to note are: Competitive energy prices tend to be forward looking and are the same for all customers and all locations unless binding constraints in delivery necessitate supply from a more expensive source until such time the constraints are resolved. Competitive retail prices tend to be cost plus in nature, and the margin may differentiate between classes of end users. Characteristics of Regulated Energy Markets In other jurisdictions, energy prices are regulated. The regulated price tends to be contracted for a period, as it is not feasible to provide a regulated spot price. Typically prices are based on actual costs, rather than marginal (or forward looking) costs. A single buyer market is an example of this. On occasion, energy prices may be benchmarked against a similar/substitute product. If the benchmark price is competitively determined, some semblance of a forward looking price may be imported into the regulated price. Regulated prices tend to be universal in the case of transmission and distribution networks which are widely regarded as natural monopoly services. As networks tend to be characterised by significant long life assets, the return of capital and return on capital constitute a significant proportion of the cost structure. Whilst some regulators allow prices to reflect marginal / forward looking costs, others only allow the recovery of actual cost. Network prices, which reflect delivery costs, provide the clearest example of potential location based pricing differences. 9 Locational pricing may occur in two ways: First, locational price differences will naturally occur in the case of unconnected (or separately licensed) networks in different geographic licence regions. As the age, value, and characteristics of networks and their customer base will differ across regions, the tariff customers pay for network services will necessarily be different. Second, as a matter of network pricing policy, some regulators (particularly in the case of transmission networks) adopt locational pricing in order to provide signals to consumers that delivery costs depend on location within the network. The 9 But not necessarily the only example of locational pricing as energy prices differentials can occur in constrained markets. 18

19 alternative, which is also widely accepted, is to apply uniform (postage stamp) tariffs. For the purposes of this consultation paper, we have assumed network prices will have a locational dimension. Regulated retail markets are broadly similar to their competitive counterparts. A notable exception may be where the regulator explicitly allows ex post compensation for customer default risks. The key points to note are: Regulated energy prices tend to be cost plus or benchmarked, and are the same for all customers and all locations. Network charges tend to be cost reflective and locationally based, although asset returns may be based on actual cost rather than marginal cost. Regulated retail prices tend to be cost plus in nature without any differentiation of end users. Approval of Maximum Prices It is noted that the Act differentiates in the case of transmission and storage tariffs between approval and regulation. Other legislation also uses different language when describing the setting of prices and tariffs by a regulator, for instance: The Petroleum Products Act, 1977 provides for the Minister to prescribe the price, or a maximum or minimum price, or a maximum and minimum price, at which any petroleum product may be sold by any person [section 1(c)]; The Petroleum Pipelines Act, 2003, provides for tariffs set by the Authority for petroleum pipelines [section 20(q)]; In the case of the maximum price for piped gas, the Piped Gas Regulations, 2007 state: Licensees must provide the Gas Regulator with sufficient information as required by the Gas regulator for it to determine maximum prices [regulation 4(7)] Approval in respect of gas prices is therefore interpreted to mean a process whereby licensees submit information along with their applications for licences to NERSA wherefrom NERSA shall evaluate the prices provided by licensees and make a determination whether it accepts such prices as satisfactory. This process is different to where NERSA informs licensees of the maximum prices to be adopted. 19

20 From the wording of the Act, the legislator has placed it within the discretion of NERSA to either accept or reject such prices should the prices proposed by licensees not be satisfactory to NERSA. For NERSA to accept the licensees proposed prices, NERSA must, from the material submitted by licensees, be able to compare the proposed prices with some consistent methodology for approving maximum prices. Gas Price Considerations The conceptual framework provides a basis for the regulated maximum price for piped gas to be determined. This is depicted in the following diagram: Upstream Industry Tx Receipt Point PIPED GAS INDUSTRY Distribution Reticulation Unlicencedand Unregulated Cost Components Gas Levies Storage Tariff Price GE LV S Licencedand Regulated Trading Tariff Tx Tariff Gas Price Max Price 1 TT Tx GE LV S Trading Tariff Dx Tariff Licenced only Max Price 2 TD Dx TT Tx GE LV S Trading Tariff Rx Tariff Price TR Rx TD Dx TT Tx GE LV S Key: Max Price Components TR = Reticulation Trading Tariff Rx = Reticulation Tariff (Pipes) TD = Distribution Trading Tariff Dx = Distribution Tariff (Pipes) TT = Trading Tariff Tx GE LV S = Tariff (Pipes) = Gas Energy (Molecules) = NERSA Levies = Gas Storage Tariff Trader Note: Red identifies tariffs regulated by NERSA Distributors Customers and Other Customers Reticulators and Other Distribution Customers Reticulation Customers The maximum price is a bundled price reflecting the following generic services: Energy (i.e. the gas molecules) Transportation (e.g. transmission and distribution) Trading; Gas storage; together with, Regulatory oversight (e.g. NERSA levies). Distribution tariffs (for both pipes and trading) are not directly regulated by NERSA. However, it is clear that NERSA has the discretion to either accept or reject distribution 20

21 prices should the prices proposed by distribution licensees not be satisfactory to NERSA. NERSA will be applying this discretion with respect to distribution tariffs should they be considered unreasonable. The alternative approach would be for NERSA to accept (unregulated) distribution tariffs as a pass through in approving maximum prices. However, this alternative approach falls short of the legislative intent. Maximum prices that pass through distribution tariffs would, in effect, simply be a cumbersome way of specifying a maximum energy price given that transmission tariffs are regulated (for both pipes and trading) and should also be passed through to the maximum price determination. Another issue is how should NERSA s efficient price benchmark (e.g. Max Price 1 and Max Price 2)be specified to ensure that it is comparable with actual prices proposed by licensees? In particular, it may be the case that licensee proposals may vary as to the way in which prices have been structured. For instance, prices may include both fixed and variable components, and transmission tariffs may (perhaps) include charges that vary according to the distance gas is transported. Upstream Industry PIPED GAS INDUSTRY Suppliers Tx Receipt Point Distribution Reticulation Max Price 1 NERSA s efficient price benchmark Max Price 2 NERSA s efficient price benchmark How to compare? How to compare? Approval Process: Proposed charge may include: Fixed daily charge Volumetric (GJ) charge Capacity charge (MDQ) Actual Trader Price less than Max Price 1 Proposed charge may include: Fixed daily charge Volumetric (GJ) charge Distribution Actual Distribution Price less than Max Price 2... where actual refers to the licensee s proposal The maximum price should be expressed simply (e.g. R/GJ). More complex price proposals are compared on the basis of the aggregate delivered cost for that supplier s customers. The structure of price across the value chain is important. In particular it provides key signals in terms of consumption and capacity utilisation, sets the risk profile, and is a key determinant in allocative efficiency. Differences in pricing structures across suppliers may 21

22 be warranted, or acceptable, on the basis of a network s utilisation or a supplier s risk appetite. In approving maximum prices NERSA is not inherently approving the structure of prices charged to a particular customer category by a single licensee. It would add significantly to the exercise of approving maximum prices for NERSA to also be responsible for determining the appropriateness of suppliers price structures (that is, whether a simple or composite price is used, allowing for a fixed and variable component). Arguably, NERSA does not have access to the information necessary to make informed decisions in all of these areas. As it is the overall delivered cost to customers that is important, rather than the manner in which price per se is expressed, NERSA proposes that the maximum price should be specified in simple volumetric terms (e.g. R/GJ). By comparing: (a) the aggregate delivered cost to the supplier s customers using NERSA s maximum prices; with, (b) the aggregate delivered cost to the supplier s customers using the licensee s proposed prices, NERSA can determine whether the proposed prices are acceptable. In addition, this method allows NERSA to specify price in one form (or in terms of an associated revenue amount) whilst enabling the flexibility of suppliers to adopt, within reason, their own equivalent price structure. In this case, equivalence is measured in terms of bundled revenue as illustrated in the following diagram. Bundled Revenue Comparison The following alternative specifications of price are 'equivalent' providing throughput is as expected Alternative 1 Simple Price Structure Price = R0.10 per GJ and if actual throughput is 1,000 GJ, then actual revenue is R100 Approach likely to be favoured by regulator for specifying its 'efficient price' benchmark for approving maximum prices Alternative 2 Compound Price Structure Price = R per GJ (variable charge) R0.05 per day (fixed charge) and if actual throughput is 1,000 GJ, then actual revenue is R100 (i.e. R81.75 variable and R18.25 fixed) Approach likely to be favoured by suppliers for specifying actual prices As a separate task in the future, it may be necessary for NERSA to consider the development of core pricing principles as part of a systematic pricing methodology that suppliers must have regard to that ensure that suppliers do not use flexible price structures to unreasonably shift risks and/or transfer value (i.e. discriminate) between customer categories/consumer classes. 22

23 Specification of Maximum Price Prices should be reflective of the value added services that accrue along the industry value chain. The preceding discussion on the value chain and replicating competitive market outcomes has important implications for the definition of the maximum price particularly in relation to maximum prices having a customer and locational dimensions. The maximum price may be expressed in formulaic terms as the price of the gas energy together with associated storage and transportation costs, trading margins, and levies The maximum price of piped gas may be expressed, generically, in the following functional form: Max Price (Trans) = GE L + Tx L + TT EC + LV +S Where: Trans = Customer Class ( Customers) GE Tx TT LV S L EC = Maximum Price for Gas Energy End Consumer Class = Pass through of regulated (network) tariffs = Pass through of regulated (trading) tariffs = Price for NERSA Levy = Pass through of approved or regulated Storage tariffs = Location = End Consumer Class GE L = Maximum Price for Gas Energy End Consumer Class per Location and: Max Price (Dist) = GE L + Tx L + Dx L + TT EC + TD EC + LV +S Where: Dist = Customer Class (Distribution Customers) GE = Maximum Price for Gas Energy End Consumer Class Tx = Pass through of regulated (network) tariffs Dx = Maximum Price for Distribution (network) tariffs TT = Pass through of regulated (trading) tariffs TD = Maximum Price for Distribution (trading) tariffs LV = Price for NERSA Levy? S = Pass through of approved or regulated Storage tariffs L = Location EC = End Consumer Class GE L = Maximum Price for Gas Energy End Consumer Class per Location Options for assessing each of these components are detailed below. In evaluating these options (later in this Discussion Document), the above functional form of the maximum gas price may, where appropriate, be refined. Questions 5.1 Are there any material inaccuracies in the conceptual framework detailed in the Consultation Document? 23

24 5.2 Is the distinction between customer categories and consumer classes (as used in this Consultation Document) appropriate? 5.3 Are customer category, consumer class, and locational dimensions to the maximum price appropriate distinguishing features? 5.4 When determining the maximum price of piped gas, is it appropriate for regulated components of the maximum price (e.g. transmission tariffs) to be treated as a passthrough? 5.5 Is NERSA s interpretation of approving maximum prices as having discretion to accept or reject prices proposed by licensees appropriate? Which other interpretations should be considered? 5.6 In approving maximum prices, is it appropriate for NERSA to compare the aggregate delivered cost to the licensee s customers using NERSA s maximum prices, with the aggregate delivered cost to the licensee s customers using the licensee s proposed prices? 24

25 6. Determining the Maximum Price of Gas Energy There is currently no existing methodology in South Africa for setting a regulated price for gas energy. As illustrated in the conceptual framework, NERSA does not have responsibility for approving a maximum price for gas purchased by the Trader. This exclusion is readily explicable since: domestic production of gas is subject to the Mineral & Petroleum Resources Development Act, 2002, for which NERSA is not the established regulator (such licensing is currently done by the Petroleum Agency of South Africa); the price of imported gas is clearly outside NERSA s jurisdiction; and the price of imported Liquefied Natural Gas (LNG) for re gasification is also outside NERSA s jurisdiction. In approving maximum prices for gas energy sold by the Trader NERSA could establish a maximum price at such a level that the Wellhead Price could not be passed on. However, unless this is warranted by specific circumstances, to do so would be contrary to several of the objectives and principles that NERSA is obliged to apply. For instance, it would not enable the Trader to: recover operational costs, unless NERSA found that these were not efficient and prudently incurred; or make a profit commensurate with risk, unless NERSA found that the costing of risk was found to be excessive. It is therefore necessary at the start of the supply chain to establish how the prudent and efficient costs of gas purchase might be determined. Upstream Industry PIPED GAS INDUSTRY A key price component that needs to be determined is the Gas Energy Cost (or the cost of the gas molecules) As observed previously, the spot price for gas in a market environment would trend towards its marginal cost (i.e. supply and demand are optimally satisfied where Marginal Revenue = Marginal Cost). In broad terms, the regulated maximum price for the gas energy component of the maximum price should shadow the hypothetical price that would occur if competition were not limited. On this basis, the maximum regulated price for gas energy will fall somewhere in the envelope bounded on the low end Cost Components Customers Gas Levies Storage Tariff Tx Receipt Point Price GE LV S Trader Trading Tariff Tx Tariff Gas Price Max Price 1 TT Tx GE LV S Distributors and Other Customers 25

26 by the cost of production 10 of gas, and on the high end by the opportunity value for consumers (their cost of a reasonable alternative fuel). This envelope can provide a large spread in potential prices when supply (or demand) is constrained, as is depicted by the shaded region in the hypothetical demand supply curve illustrated below: 100 Hypothetical Gas Supply Demand Curve Zar/GJ PM Quantity (PJ) Supply Constraint Supply Demand It should be noted: the market price determined through competitive interaction is expected to be P M, the marginal price which balances supply with demand. in a supply constrained market, suppliers, if not regulated, would tend to set prices at the higher end, dominated by the higher opportunity cost of purchasers. This latter outcome (which may result in Market Value Pricing) is inefficient, and results in a deadweight loss to the economy as a whole. Market Value Pricing enables a monopolist to exploit its position in the market if it can prevent on selling of gas. The result is a transfer of all economic surpluses to the producer resulting in an unfair distribution. This can occur where contract prices (in the case of a long term Gas Supply Agreement), or production costs (in the case of existing gas production) are below new entrant (marginal) production costs. Inefficient outcomes also occur when prices are suppressed artificially. The lower cost structure of incumbents can be used by suppliers (deliberately) or by regulators 10 Production refers to the cost of the gas at the receipt point of the transmission system. This may include the cost of gas delivered to the receipt point in the case of imports (including regasified LNG). 26

27 (inadvertently) to reduce competition (i.e. low prices may be a barrier to entry). Regulating prices at below market prices (or LRMC) can result in damage to the supply side incentives. Supply may be deferred or even worse curtailed and incentives for future investment or supply will be negatively impacted with resulting future price shock a possibility. As noted previously, the price of gas energy (i.e. the commodity) should be the same at all locations unless differential prices are the economically efficient solution to binding network constraints (i.e. the choice is between the delivered cost of: (a) gas piped from a local but expensive source; or, (b) gas from extending the gas network to source non local but cheaper gas). Prices (for the same commodity) should not discriminate amongst consumers (e.g. as Market Value Pricing does), as in a competitive market arbitrage opportunities will ensure prices trend towards marginal cost. Market Value Pricing, as defined in Schedule One to the Agreement Concerning the Mozambican Gas Pipeline is incompatible with the non discrimination requirements of the Gas Act. Similarly, regulating gas prices to reflect the average production cost of gas suppliers, rather than the marginal cost of supply, is theoretically inefficient. Arguably the role of the regulator with respect to gas energy is different than its role with respect to the provision of monopoly services. Whilst the transmission and distribution components are generally regarded as monopoly services due to their scale economies (i.e. high fixed network cost) and absence of competing technologies, the provision of gas energy and gas trading are both contestable. It should further be noted that transmission pipelines are not granted exclusive areas (i.e. considered monopoly services) in terms of the Gas Act, and that any monopoly aspects of these pipelines are likely to be geographical in nature only. The regulation of gas energy should facilitate contestability rather than entrench supply constraints. This means that it is appropriate for the regulator to ensure existing arrangements are not barriers to entry/competition. The best regulatory option is to seek to replicate market outcomes and set the maximum price for gas energy as closely as possible to the marginal cost of supply. (i) Marginal costs of supply The long run marginal costs of supplying gas at particular locations, with suitable modifications to reflect the depletion of gas reserves, economies of scale in developing production and supply facilities and the timing and nature of investments, may be used to approximate market prices. One approach to this is to determine the average incremental cost, determined by discounting future incremental costs to provide the required amount of gas over a given time period divided by the discounted volume of incremental output. The use of annual volumes reflective of the depletion profile can be accommodated by this method. 27