1. Review of economic regulation of liquid fuels and related products
Pamela Mondliwa and Simon Roberts
CCRED
Centre for Competition, Regulation
and Economic Development
University of Johannesburg

2. A. Overview Description of evolving regulatory framework
Different standards against which regulatory framework can be assessed, and government reviews undertaken
Linkages between regulation of fuels and related products and economic growth
Case study of fuel regulation, competition enforcement and polymer chemicals
Case study of piped gas regulation
Conclusions

3. Objectives of the Study
Part of wider project reviewing economic regulation
In terms of development of economy and economic policy
In terms of different rationale for regulation
Input to measures to improve capacity of regulators
Key questions
Effects of regulation of pricing and access in liquid fuels and distribution over time, against objectives of restraining market power and fair internationally competitive prices, ensuring security of supply, incentivizing investment, and increasing participation (including HDSA)
Impact of regulatory framework of fuel for related products
Assessment of regulation of piped gas pricing in light of learning from experience
Why there have been observed changes, and how does this represent the balancing of different interests

4. Fuel and related products supply chain
Coal
Crude Oil
Petrol
Diesel
IP*
LPG
Bitumen 
Gas
By products and chemical feedstocks, such as ammonia and monomers
Fuel Wholesale
Polymers
 Ammonium nitrate, MAP & DAP
Fuel Retail
Plastic Products
Fertilizer
 Refining and synthesizing
Distribution via pipelines and road

5. Why regulate fuel? Considering the rationale for regulation:
The natural monopoly problem and market power
Externalities and market failures
Assessing the private and social returns
Large capital investments, state support and geography have meant entrenched inland position of Sasol and Natref
Also reason for coordination by state, and for longer term view underpinning investments (lower discount rate)
Value placed on local production of liquid fuels and security of supply
Different basis under apartheid given threat of sanctions
Environmental concerns

6. Net trade: local demand outstripping supply for liquid fuels

7. Performance: output (VA)

8. B. Regulatory framework: history
State took over price setting role in 1946 from industry (had previously been self regulating with industry controlling price and access)
Sought to develop local fuel production
Sasol was built as part of the States oil security strategy
Main Supply Agreement (1954)
constituted a government-brokered and sanctioned form of private regulation
oil companies were required to purchase all of Sasol’s production volumes pro-rata to their market shares for marketing in the inland region
The petroleum industry was also exempted from the competition law between 1988 and 2001.

9. Regulatory framework: changes since 1994
MSA continued to end 2003; Industry barriers were maintained
Protection continued, then removed in 2000
Had provided that if the oil price were below $23/bbl, protection
If oil prices were above $28.7/bbl, windfall gains repaid
Prices regulated at In Bond Landed Cost (IBLC)
Choice of majority Singapore refineries as a reference
The use of posted prices (100% pre 1994, 80% ) as opposed to spot prices
Review indicated above true import parity
Move to Basic Fuel Price in 2003 which used better assessments of what fuel could be imported for; and more appropriate international sources
Singapore was one of the most expensive refining areas from which to buy fuel
Since Singapore is further from Durban than the the Arab Gulf and Mediterranean, this increased the shipping element of IBLC
Singapore markets based on fuel rather than petrol, the petrol market was less developed and thus more expensive. Whereas in the SA market is petrol is the most important petroleum product
Posted prices were the standard pricing mechanism for exports between 1950 to 1970s, thereafter sales were done on the spot prices Freight rates

10. 1994
Change in import parity price calculation (for refined product at refinery gate) from 100% posted prices to 80% posted and 20% spot prices for the selected international markets (posted prices generally higher)
Reference refineries were changed to include wider basket (Arab gulf, Mediterranean in addition to Singapore which was generally more expensive and further away)
2000
Equalisation fund discontinued (retail price smoothing, effective SSF tariff protection, synfuel levy, crude oil price premiums paid by SFF to circumvent oil sanctions)
Slate levy introduced as smoothing mechanism
2003
Move from IBLC to BFP basis for the import parity price calculation
Change from 80% posted prices to full spot prices (of the reference refineries)
approx 9% reduction to the retail price (as % of refinery gate price)?
2010
Move from MPAR to Regulatory Accounting System (RAS)

11. Current regulation and institutions
Policies & Objectives
Petroleum Products Act (1977), amended 2003 and 2005
Energy White Paper (1998):
Short and medium term objective to re-regulate the liquid fuels industry to achieve higher levels of competition and unrestricted market access
Long term objective of deregulation (removing price and trade controls)
Replacing MPAR with RAS in 2010:
To locate margins at level where costs incurred.
Short coming: the model is based on Retailer-Owned, Retailer-Operated stations (40% of market, CORO is 60%)
Some (limited) opening up to independent traders, increased in around 2011

12. Institutions
DoE
Nersa
Competition Authorities
Role played by industry in (self)regulation – SAPIA and oil companies

13. Progress with liberalization (against White Paper)
Phase 1 milestones (still only partially met)
Sustainable presence, ownership/control by HDSAs of ~25% NO
Mutually acceptable arrangements between producers & marketers of fuel on the upliftment & marketing of synfuels YES
equitable participation of small businesses in the industry NOT ENTIRELY
The introduction of suitable transitional arrangements within the Service Station Rationalisation Plan YES
Equip regulator with capacity required to adequately monitor possible post deregulation distortions and address these NOT ENTIRELY
arrangements to address any labour related consequences of deregulation NO
capacity to license and/or regulate oil and liquid fuel pipelines storage facilities if this is found necessary YES
Phase 2 milestones
Retail price regulation, import control and Government support for the Service Station Rationalisation Plan will be simultaneously removed
Phase 3 milestones
Government will monitor and evaluate possible problems arising from the introduction of deregulation and will take corrective action

14. C. Assessing economic regulation
Previous assessments
Liquid Fuels Industry Task Team (1994)
Arthur Andersen (1995)
PVM
Windfall Tax Team (2006/07)
Nedlac Administered Prices study (2011)
Concerns
Post 1994: IBLC benchmarks and data at above actual IPP levels
Since mid-2000s: MPAR, non regulated products
Critical review

15. Regulation affects firm strategies, determines outcomes: developments of Sasol-Engen merger
Sasol decision to give notice on MSA - part of strategy to respond to anticipated liberalisation:
Notice in 1998 for MSA to end Dec 2003
OOCs do not have to buy Sasol product (so can bargain for lower prices); Sasol can move downstream
NB MSA had only been granted limited exemption by Competition Commission
Sasol acquisition of OOC means instant distribution network – do not have to rely on OOCs for sale of product
Take bigger stake in crude oil refining – coastal refiners have surplus
Explored acquisitions of various OOCs (refining and marketing/ distribution operations), decided on Engen
Tribunal blocked merger as found Engen acquisition reinforced market power in inland market

16. Sasol-Engen (uHambo merger)
Sasol decision to give notice on MSA part of strategy to respond to anticipated liberalisation:
Move downstream so as not to rely on OOCs for sale of product
Take bigger stake in crude oil refining
NB MSA had only been granted limited exemption by Competition Commission
Explored acquisitions of various OOCs (refining and marketing/distribution operations)
Tribunal found Engen acquisition reinforced market power in inland market as:
Power constrained by Sasol’s reliance on OOCs as customers
Sasol vertically integrating downstream would change the bargaining game which had seen inland discounts

17. Sasol-Engen merger cont.
Tribunal found credible threat by Sasol to foreclose (refuse to supply) OOCs given the merger
Vertically integrating downstream would change the bargaining game which had seen inland discounts, as OOCs had countervailing power
Tribunal hearing revealed strategy, exclusion, bargaining games
Sasol had responded to OOCs bargaining for discounts by:
Commit to cut back production (at Natref); by-pass OOCs thru exports
OOCs: ability to turn to coastal volumes through pipeline, rail, road
Synfuels pricing internally had reflected its poor alternatives
Cannot easily vary production; very low variable costs
Should be willing to sell at prices far below inland IPP, absent creating commitment to maintain these prices
Structure of transaction to lock-in inland IPP prices for 10 years
In the end, did not need merger as demand increase, and logistics constraints – pipeline capacity and cost are critical

18. Windfall tax team
Against backdrop of structural increase in oil prices (and other natural resources)
This meant a ‘windfall’ for synfuels producers with low cost feedstock and established capacity
Had been ‘tariff protection’ with floor price (of $23/bbl) and refund above ceiling price
Taskteam Brief (multiple objectives reflecting different priorities in government)
Fiscal response to situation of higher oil prices
Improved efficiency of value chain, transmission to consumers
Future investment to meet accelerated growth, employment, Reduce volatility of fuel price
Energy policy objectives, including security of supply

19. Windfall tax team – main findings
Rents/excessive profits arise at different levels:
Upstream oil & gas (linked to royalties)
Excessive synfuels profits – different cost structure and IPP basis for pricing
Inland ‘must have’ fuel volumes not subject to supply competition because infrastructure constraints: regulatory reform and/or fiscal measures
Recommended: smart regulation package, together with fiscal measures
Regulation improvements: remove import control; BFP be over-hauled to get price closer to ‘true IPP’; change petrol to price cap; regulate pipeline tariffs
Address inland market power: Until logistics constraints removed in inland market regulation of prices at level approximating competitive market prices
Special levy on synfuels triggered by oil price above specified level – independent study had recommended $28/bbl in 2000 (could be updated for inflation)
Incentivising new investment in local fuels (aside from crude oil and imported natural gas), i.e. including synfuels
Noted existing regulatory reform: MPAR being reviewed (wholesale margin); Retail margin no longer regulated
Noted likely windfall profits from Sasol privatization, but not in ToR

20. Windfall tax team – what happened next?
Findings noted by NT in 2007
Regulatory recommendations referred to Ministry of Minerals & Energy (was not part of Windfall Tax process)
Noted that ‘most countries’ used royalties, production sharing agreements or state equity (UK has higher taxes over threshold?)
Noted negative effect of higher taxation on investment, and policy objective to reduce dependence on imported fuel
No further action taken regarding regulating synfuels inland prices, or progressive taxation structure
NT indicated that Cabinet ‘effectively’ released Sasol from obligation to repay subsidies in 1998, provided it continued to develop the petrochemicals sector

21. Cont.
Quid pro quo?
NT welcomed Sasol commitment to feasibility of investing in Project Mafutha CTL and possibility of GTL upstream investment in refining
Would ‘hold Sasol to its commitment to significantly expand its synthetic fuel production capacity in support of national interest in terms of fuel security and macroeconomic stability’
Sasol promoting new Mafutha synfuels in Waterberg, but:
only with substantial government (IDC financing) and guarantees
big concerns about CO2 emissions and water use
not clear would lead to lower prices under existing regulation.
Bottom line? No enforceable agreement, no credible commitments
Sasol not making investments in expanding refining
investments made related to clean fuels (Project Turbo) and more recently in polymers; but, not leading to more competitive prices, simply those in its narrow interests

22. Criteria against which to make assessment?
Market power
Price control?
Regulating access?
Investment?
Security of supply?
Diversification and industrial development?

23. Critical assessment – learning from the past
Firms had achieved high margins, by:
Effectively self regulating
Leveraging from legitimate concerns about security of supply to custodianship being passed to industry
Influencing what measures were used (IBLC) and what data were used to do the measurement (spot v posted; Singapore refineries etc)
Rate of return on marketing assets means ‘gold-plating’ very weak incentives for efficiency
Insiders as gatekeepers, even in trading and retail
Competition undermined, even where it would have been possible
Unwinding historical arrangements, but legacy persists

24. Criteria – addressing market power
Control over infrastructure
Inland position – ‘location advantage’
Lily Pipeline – was used for strategic crude oil stocks; Sasol secured it for industrial gas to KZN (preventing it being used for bringing product inland)
Control over productive capacity and technology
PetroSA restrictions
Competition investigations:
Exemption for MSA – restricting competition
Information exchange in fuel
Merger control
Allocating customers and dividing markets?
Polymer chemicals
Fertilizer

25. Assessing regulation: assessing investment and security of supply
Distinguish between:
Local refining from imported crude (does this increase security?)
Production from local (regional?) feedstock
Security means accessing supplies:
can import, with efficient distribution
Access to distribution:
Insiders have controlled and argued for centralized coordination
Competition means greater responsiveness to demand, increased participation, lower information requirements on reg
Investment decisions in refining?
Mafutha? Umthombo? Role of PetroSA? Regional dimensions?
Considering refining as part of petrochemicals production?

26. Regulation of fuel and economic development – adopting a wider lens
Fuel is part of petrochemicals industry, not stand alone
Key linkages with upstream feedstock: coal, oil, natural gas
And, with infrastructure: pipelines, rail, storage
Requires major investments in large scale plant and site
Consider as part of economic structure
Linkages
Agencies, that is, different interests
Evaluate sector development as part of industrial policy - development of pattern of comparative advantages and capabilities

27. Regulation and development of fuel and chemicals
Complex and diversified sector
Industries in this sector are highly inter-linked
Well-developed upstream & underdeveloped downstream
Largest broad manufacturing grouping in terms of value-added
Third largest employer in manufacturing: relatively capital-intensive upstream and more labour-intensive downstream

28. Performance of different parts of industry?
Average growth of plastics sector (value-added at factor cost, constant prices) compared to coke & refineries and basic chemicals (Quantec data):
Plastic products: 1.8%
Coke & refineries: 6.0%
Basic chemicals: 4.9%
Other chemicals and man-made fibers: 4.7% :
Plastic products: -3.4%
Coke & refineries: 4.8%
Basic chemicals: 2.8%
Other chemicals and man-made fibers: -0.5%
Trade deficit
Plastic products net trade deficit trebled from 2002 to 2011, to R4.9bn (constant 2005 prices)
Employment: more than 25% of jobs lost in plastic products since peak in 2000
Plastic products should be growing more rapidly than GDP and than upstream sectors in diversified industrialising economy

29. Performance of different firms?
Data on listed firms indicates that mark-ups are very high in petroleum and basic chemical products:
Aghion et al. (2008) est of price mark-ups over marginal cost for found coke & petroleum products 2nd highest manufacturing sector (at c330% mark-up)
Chemicals profits (net income to asset ratio) in South Africa is more than 2.5 times the world average
The adjustments made to the IPP calculations indicate that refiners have been earning above IPP prices
Windfall Tax Study indicated very high margins for synfuels producers give the prevailing crude oil price
NB PetroSA had been obliged to sell to OOCs at export parity
Downstream sectors (plastic products) performing poorly

30. Economic policies to support industry?
Industrial policy and incentives
Trade policy
Environment
Mining/natural resources policy
Regional development
What coordination between these?

31. E. Case study of linkages of fuels to chemicals & manufacturing: propylene and polypropylene
Context:
Propylene is by-product of synfuels, produced in very high proportions (relative to ethylene)
Investments to produce propylene are part of liquid fuels
Not subject to regulation
Can be combined into fuel pool (for petrol, diesel) to limited extent and with further processing required
There is a ‘fuel alternative value’ which for Synfuels is relatively low
Propylene made into Polypropylene
This is key input to plastics, and priced at IPP level despite net exports of around half of production

32. Case study: history
Sasol had apparently changed behaviour in 1995, Arthur Andersen review found:
Sasol was not charging IPP for number of by-products and co-products
Prices were in line with net export prices for various products such as PP
This meant downstream industries were not disadvantaged
Sasol then returned to IPP by at least 2000
Competition regime meant to address dominant firm conduct, including excessive pricing
DTI concern about poor growth of labour-absorbing downstream industries, such as plastic products

33. Plastics trade performance: major categories

34. Polymers cont.
DTI requested Competition Commission to investigate polymer pricing in 2007
Commission initiation after initial research. Case referred by Commission on excessive pricing of propylene & PP
Tribunal hearing concluded in 2013, decision pending
Sasol arguments on definition of economic value
The advantage from cheap feedstock is a special advantage that Sasol should retain profits from
How to assess return on capital – replacement cost, shared costs
Common cause that: Sasol costs of producing PP are lower than almost all other countries while its prices to local customers have been higher
No other policies pursued in meantime (industrial policies, regulatory measures)

35. Case study: Gas regulation?
Regulation is understood in terms of price and access
Prices are controlled because otherwise they would be set at monopoly levels
Regulation thus seeks to control the rents that accrue as a result of market failures
These rents represent the excess income that is achieved over and above the next best alternative.
However, this excess is sometimes required to attract capital into a particular market
This complicates the role of the regulator as they have to distinguish when it is efficient to allow high profits and when it will retard growth
Gas Act Identifies stimulating investment and fair and competitive prices as its objectives
Requires the regulator to make choices about which interests to prioritise when taking its decisions

36. Legislation relating to the Gas Market
In 2001, Sasol Gas needed to make investment decisions regarding Mozambique gas, but there was no specific legislation for gas projects at the time
the South African Government and Sasol Gas concluded the “RSA Regulatory Agreement”, giving Sasol Gas a Special Regulatory Dispensation regarding exclusive rights to ROMPCO’s infrastructure for a period of 10 years from the first gas received by Sasol.
The agreement also had obligations relating to the supply of piped gas to customer and third party access to the Mozambique pipeline and Sasol’s own pipelines
The Gas Act was enacted in 2002 and enforced the RSA Regulatory Agreement mandating NERSA to control access through licensing and registrations and prices through maximum piped gas prices post the special dispensation
The special dispensation period comes to an end on 25 March 2014

37. Gas prices under the special dispensation
Sasol Gas priced using the market value pricing principle (MVP)
Where MVP was defined as the determination of the gas price in comparison with:
the cost of the alternative fuel delivered to the customer’s premises (in the case of Greenfields Customers); plus
the difference between all the operating costs of the customer’s use of the alternative fuel and all the operating costs of using natural gas; plus
the difference between the Nett Present Value (NPV) of the capital costs of the customer’s continued use of the alternative fuel and the NPV of the capital costs involved in switching to natural gas,
This pricing methodology produced a price cap for Sasol Gas and it could negotiate with individual customers.
Sasol Gas was allowed to offer discounts on the MVP based on annual quantity purchases

38. There was an additional clause to cap the average prices
The purpose was to limit Sasol Gas revenues compared to a benchmark
The benchmark was the European Benchmark Price established using data from Spain, Netherlands, Belgium, Italy France and Germany.
The Sasol volume weighted average gas price was not allowed to exceed the EBP
In the event that it did customers were eligible for refunds from Sasol Gas

39. The Gas Act
NERSA to set prices for distributors, reticulators and all classes of customers, where there is inadequate competition
requires non-discrimination prices, tariffs and other conditions
Gas Act mandates NERSA to ‘approve maximum prices for distributors, reticulators and all classes of customers, where there is inadequate competition’
Based on the legislative provisions NERSA developed two sets of methodologies:
Tariff Guidelines, 2009, applicable to transmission and storage tariffs
Maximum Prices Methodology, applicable to the price for gas energy (molecule)
In February 2012, NERSA determined ‘inadequate competition’ in gas

40. Maximum prices as per NERSA (gas energy price)
Maximum price based on a weighting of prices of alternative sources
Coal, diesel, electricity, HFO and LPG
Weights are derived by total energy consumption of the selected sources:
Coal (36.2%), diesel (24.8%) and electricity (37.1%)
Prices of sources derived from available benchmarks
Coal is the FOB Richards bay price
Diesel is the BFP for diesel
Electricity is the Eskom average tariff
HFO is the DOE price
LPG is the maximum Refinery Gate Price (Coast)

41. Evaluation- Special Dispensation
The MVP effectively allows maximum exertion of market power up to alternative.
NERSA has not found that the Sasol volume weighted average gas price has exceeded the EBP
Is the European Benchmark appropriate considering that the Gas is mainly sourced from Russia and Algeria (longer transmission distances)
The comparison is of SASOL customers consuming up to 10 million GJ pa and the EBP customers consuming a maximum of GJ pa
Should the EBP comparison be done on a customer category level rather than using average prices?

42. Comparing International gas price by consumption category (NUS survey for 4500GJ pa comparable –SA class 3)

43. New Dispensation:
Weights based on total rather than industry energy consumption
FOB Export coal prices are used rather than ex-mine prices
Export grade coal used rather than grades bought by local industry
Average elec tariff used rather than the industrial tariff (or even megaflex)

44. Implications of different benchmark prices
Choice of benchmarks matters
The local the bituminous coal price is R460/t cheaper than the export FOB price (DOE Energy price Report, 2012)
The average electricity rate 8.03 c/kwh higher than the industrial users rate (DOE Energy price Report, 2012).
Illustrative exercise for 2011
Calculated Maximum gas energy price for 2011 (NERSA data) –R103.40
Using the Industry sector energy consumption balances in the calculation of the weights alone decreases the 2011 maximum gas price by 17%
Using the industrial electricity price instead of Eskom average reduces the calculated maximum gas price by 8%
Using the local coal price instead of FOB Richards Bay 7%

45. SA Energy consumption vs Industry consumption
Overall consumption
Industry Sector
Overall Consumption (TJ)
Weights
Industry Sector consumption (TJ)
Coal
759858
36.2%
460245
49.55%
Diesel
520952
24.8%
50628
5.45%
Electricity
779140
37.1%
417595
44.96%
HFO
23648
1.1%
364
0.02%
LPG
17323
0.8%
0.00%
928833
was
Industry Sector incl:
Iron and Steel
Chemical and Petrochemical
Non-Ferrous Metals
Non-Metallic Minerals
Transport Equipment
Machinery
Mining and Quarrying
Food and Tobacco
Paper Pulp and Print
Wood and Wood Products
Construction
Textile and Leather
Non-specified (Industry)

46. Illustrative exercise (2011)
Weights (industry)
Price-A (R/GJ)
Price-B (R/GJ)
Coal
49.55%
15.47
3.60
Diesel
5.45%
8.49
Electricity
44.96%
61.79
52.61
HFO
0.04%
0.05
LPG 0%
0.00
Weighted Maximum
100%
85.81
64.75
Price-A: Calculated using benchmarks as stipulated in the methodology
Price-B: Changed the thermal coal price to FOR and electricity price to industry tariff

47. Approved Maximum Piped Gas Price
GJ p.a
Gas Energy Price (GE) - R/GJ forecast 2014
Reductions %
Reduction (R/GJ)
Sasol GE (R/GJ) (26/3/2014)
NERSA approved (26/3/2013)
Class 1
< 400
128
7.50%
9.6
R 118 R
Class 2
Class 3
15.00%
19.2
R 109 R
Class 4
22.50%
28.8
R 99
R 91.21
Class 5
30.00%
38.4
R 90
R 82.38
Class 6
>
37.50% 48
R 80
R 73.56

48. Breakdown of impact of price decision by customer Size
Total
Total in %
volume
% Volume
*Small Customers that will/ may face decreases
268
58% 3%
Small Customers that may face increases 74
16% 2%
#Large Customers that may/will face decreases 66
14%
36%
Large Customers that may face increases 57
12%
59%
Total customers
465
100%
All Customers facing price decreases
72%
39%
All Customers facing price increase
28%
61%

49. Sasol Gas Turnover and Operating Profit
SA Energy: Sasol Gas
Financial Year
2012
2011
2010
2009
2008
2007
2006
2005
Turnover
R m
6931
5445
5371
5666
4697
3702
3209
2404
Operating profit
2985
2578
2479
2424
1785
1936
1526
931
Operating profit margin % 43 47 46 38 52 48 39

50. F. Conclusions?
Regulatory framework continued to benefit upstream industry for many years
Now evident in re-assessments of margins, benchmarks used
The ‘deals’ brokered with the industry under apartheid had a rationale in terms of investment and support for Sasol
Rationales have changed, but implications persist?
Continued balance towards investment returns even where new investment is unlikely
Government has continued to privilege a particular view of security of supply considerations oriented to insiders
Investment concerns motivated by Sasol appeared to trump stronger interventions (Windfall tax)
Industry structured now more skewed to upstream than in 1994
Regulatory framework sets ‘rules of the game’, balancing interests
Are the outcomes consistent with required balance?