Presentation on theme: "Review of economic regulation of liquid fuels and related products"— Presentation transcript:
1Review of economic regulation of liquid fuels and related products Pamela Mondliwa and Simon RobertsCCREDCentre for Competition, Regulationand Economic DevelopmentUniversity of Johannesburg
2A. Overview Description of evolving regulatory framework Different standards against which regulatory framework can be assessed, and government reviews undertakenLinkages between regulation of fuels and related products and economic growthCase study of fuel regulation, competition enforcement and polymer chemicalsCase study of piped gas regulationConclusions
3Objectives of the Study Part of wider project reviewing economic regulationIn terms of development of economy and economic policyIn terms of different rationale for regulationInput to measures to improve capacity of regulatorsKey questionsEffects 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 productsAssessment of regulation of piped gas pricing in light of learning from experienceWhy there have been observed changes, and how does this represent the balancing of different interests
4Fuel and related products supply chain CoalCrude OilPetrolDieselIP*LPGBitumen GasBy products and chemical feedstocks, such as ammonia and monomersFuel WholesalePolymers Ammonium nitrate, MAP & DAPFuel RetailPlastic ProductsFertilizer Refining and synthesizingDistribution via pipelines and road
5Why regulate fuel? Considering the rationale for regulation: The natural monopoly problem and market powerExternalities and market failuresAssessing the private and social returnsLarge capital investments, state support and geography have meant entrenched inland position of Sasol and NatrefAlso 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 supplyDifferent basis under apartheid given threat of sanctionsEnvironmental concerns
6Net trade: local demand outstripping supply for liquid fuels
8B. 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 productionSasol was built as part of the States oil security strategyMain Supply Agreement (1954)constituted a government-brokered and sanctioned form of private regulationoil companies were required to purchase all of Sasol’s production volumes pro-rata to their market shares for marketing in the inland regionThe petroleum industry was also exempted from the competition law between 1988 and 2001.
9Regulatory framework: changes since 1994 MSA continued to end 2003; Industry barriers were maintainedProtection continued, then removed in 2000Had provided that if the oil price were below $23/bbl, protectionIf oil prices were above $28.7/bbl, windfall gains repaidPrices regulated at In Bond Landed Cost (IBLC)Choice of majority Singapore refineries as a referenceThe use of posted prices (100% pre 1994, 80% ) as opposed to spot pricesReview indicated above true import parityMove to Basic Fuel Price in 2003 which used better assessments of what fuel could be imported for; and more appropriate international sourcesSingapore was one of the most expensive refining areas from which to buy fuelSince Singapore is further from Durban than the the Arab Gulf and Mediterranean, this increased the shipping element of IBLCSingapore 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 productPosted prices were the standard pricing mechanism for exports between 1950 to 1970s, thereafter sales were done on the spot prices Freight rates
101994Change 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)2000Equalisation 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 mechanism2003Move from IBLC to BFP basis for the import parity price calculationChange from 80% posted prices to full spot prices (of the reference refineries)approx 9% reduction to the retail price (as % of refinery gate price)?2010Move from MPAR to Regulatory Accounting System (RAS)
11Current regulation and institutions Policies & ObjectivesPetroleum Products Act (1977), amended 2003 and 2005Energy White Paper (1998):Short and medium term objective to re-regulate the liquid fuels industry to achieve higher levels of competition and unrestricted market accessLong 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
12InstitutionsDoENersaCompetition AuthoritiesRole played by industry in (self)regulation – SAPIA and oil companies
13Progress with liberalization (against White Paper) Phase 1 milestones (still only partially met)Sustainable presence, ownership/control by HDSAs of ~25% NOMutually acceptable arrangements between producers & marketers of fuel on the upliftment & marketing of synfuels YESequitable participation of small businesses in the industry NOT ENTIRELYThe introduction of suitable transitional arrangements within the Service Station Rationalisation Plan YESEquip regulator with capacity required to adequately monitor possible post deregulation distortions and address these NOT ENTIRELYarrangements to address any labour related consequences of deregulation NOcapacity to license and/or regulate oil and liquid fuel pipelines storage facilities if this is found necessary YESPhase 2 milestonesRetail price regulation, import control and Government support for the Service Station Rationalisation Plan will be simultaneously removedPhase 3 milestonesGovernment will monitor and evaluate possible problems arising from the introduction of deregulation and will take corrective action
14C. Assessing economic regulation Previous assessmentsLiquid Fuels Industry Task Team (1994)Arthur Andersen (1995)PVMWindfall Tax Team (2006/07)Nedlac Administered Prices study (2011)ConcernsPost 1994: IBLC benchmarks and data at above actual IPP levelsSince mid-2000s: MPAR, non regulated productsCritical review
15Regulation 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 2003OOCs do not have to buy Sasol product (so can bargain for lower prices); Sasol can move downstreamNB MSA had only been granted limited exemption by Competition CommissionSasol acquisition of OOC means instant distribution network – do not have to rely on OOCs for sale of productTake bigger stake in crude oil refining – coastal refiners have surplusExplored acquisitions of various OOCs (refining and marketing/ distribution operations), decided on EngenTribunal blocked merger as found Engen acquisition reinforced market power in inland market
16Sasol-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 productTake bigger stake in crude oil refiningNB MSA had only been granted limited exemption by Competition CommissionExplored 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 customersSasol vertically integrating downstream would change the bargaining game which had seen inland discounts
17Sasol-Engen merger cont. Tribunal found credible threat by Sasol to foreclose (refuse to supply) OOCs given the mergerVertically integrating downstream would change the bargaining game which had seen inland discounts, as OOCs had countervailing powerTribunal hearing revealed strategy, exclusion, bargaining gamesSasol had responded to OOCs bargaining for discounts by:Commit to cut back production (at Natref); by-pass OOCs thru exportsOOCs: ability to turn to coastal volumes through pipeline, rail, roadSynfuels pricing internally had reflected its poor alternativesCannot easily vary production; very low variable costsShould be willing to sell at prices far below inland IPP, absent creating commitment to maintain these pricesStructure of transaction to lock-in inland IPP prices for 10 yearsIn the end, did not need merger as demand increase, and logistics constraints – pipeline capacity and cost are critical
18Windfall tax teamAgainst backdrop of structural increase in oil prices (and other natural resources)This meant a ‘windfall’ for synfuels producers with low cost feedstock and established capacityHad been ‘tariff protection’ with floor price (of $23/bbl) and refund above ceiling priceTaskteam Brief (multiple objectives reflecting different priorities in government)Fiscal response to situation of higher oil pricesImproved efficiency of value chain, transmission to consumersFuture investment to meet accelerated growth, employment, Reduce volatility of fuel priceEnergy policy objectives, including security of supply
19Windfall 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 pricingInland ‘must have’ fuel volumes not subject to supply competition because infrastructure constraints: regulatory reform and/or fiscal measuresRecommended: smart regulation package, together with fiscal measuresRegulation improvements: remove import control; BFP be over-hauled to get price closer to ‘true IPP’; change petrol to price cap; regulate pipeline tariffsAddress inland market power: Until logistics constraints removed in inland market regulation of prices at level approximating competitive market pricesSpecial 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 synfuelsNoted existing regulatory reform: MPAR being reviewed (wholesale margin); Retail margin no longer regulatedNoted likely windfall profits from Sasol privatization, but not in ToR
20Windfall tax team – what happened next? Findings noted by NT in 2007Regulatory 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 fuelNo further action taken regarding regulating synfuels inland prices, or progressive taxation structureNT indicated that Cabinet ‘effectively’ released Sasol from obligation to repay subsidies in 1998, provided it continued to develop the petrochemicals sector
21Cont.Quid pro quo?NT welcomed Sasol commitment to feasibility of investing in Project Mafutha CTL and possibility of GTL upstream investment in refiningWould ‘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 guaranteesbig concerns about CO2 emissions and water usenot clear would lead to lower prices under existing regulation.Bottom line? No enforceable agreement, no credible commitmentsSasol not making investments in expanding refininginvestments 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
22Criteria against which to make assessment? Market powerPrice control?Regulating access?Investment?Security of supply?Diversification and industrial development?
23Critical assessment – learning from the past Firms had achieved high margins, by:Effectively self regulatingLeveraging from legitimate concerns about security of supply to custodianship being passed to industryInfluencing 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 efficiencyInsiders as gatekeepers, even in trading and retailCompetition undermined, even where it would have been possibleUnwinding historical arrangements, but legacy persists
24Criteria – addressing market power Control over infrastructureInland 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 technologyPetroSA restrictionsCompetition investigations:Exemption for MSA – restricting competitionInformation exchange in fuelMerger controlAllocating customers and dividing markets?Polymer chemicalsFertilizer
25Assessing regulation: assessing investment and security of supply Distinguish between:Local refining from imported crude (does this increase security?)Production from local (regional?) feedstockSecurity means accessing supplies:can import, with efficient distributionAccess to distribution:Insiders have controlled and argued for centralized coordinationCompetition means greater responsiveness to demand, increased participation, lower information requirements on regInvestment decisions in refining?Mafutha? Umthombo? Role of PetroSA? Regional dimensions?Considering refining as part of petrochemicals production?
26Regulation of fuel and economic development – adopting a wider lens Fuel is part of petrochemicals industry, not stand aloneKey linkages with upstream feedstock: coal, oil, natural gasAnd, with infrastructure: pipelines, rail, storageRequires major investments in large scale plant and siteConsider as part of economic structureLinkagesAgencies, that is, different interestsEvaluate sector development as part of industrial policy - development of pattern of comparative advantages and capabilities
27Regulation and development of fuel and chemicals Complex and diversified sectorIndustries in this sector are highly inter-linkedWell-developed upstream & underdeveloped downstreamLargest broad manufacturing grouping in terms of value-addedThird largest employer in manufacturing: relatively capital-intensive upstream and more labour-intensive downstream
28Performance 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 deficitPlastic 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 2000Plastic products should be growing more rapidly than GDP and than upstream sectors in diversified industrialising economy
29Performance 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 averageThe adjustments made to the IPP calculations indicate that refiners have been earning above IPP pricesWindfall Tax Study indicated very high margins for synfuels producers give the prevailing crude oil priceNB PetroSA had been obliged to sell to OOCs at export parityDownstream sectors (plastic products) performing poorly
30Economic policies to support industry? Industrial policy and incentivesTrade policyEnvironmentMining/natural resources policyRegional developmentWhat coordination between these?
31E. 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 fuelsNot subject to regulationCan be combined into fuel pool (for petrol, diesel) to limited extent and with further processing requiredThere is a ‘fuel alternative value’ which for Synfuels is relatively lowPropylene made into PolypropyleneThis is key input to plastics, and priced at IPP level despite net exports of around half of production
32Case study: historySasol had apparently changed behaviour in 1995, Arthur Andersen review found:Sasol was not charging IPP for number of by-products and co-productsPrices were in line with net export prices for various products such as PPThis meant downstream industries were not disadvantagedSasol then returned to IPP by at least 2000Competition regime meant to address dominant firm conduct, including excessive pricingDTI concern about poor growth of labour-absorbing downstream industries, such as plastic products
34Polymers cont.DTI requested Competition Commission to investigate polymer pricing in 2007Commission initiation after initial research. Case referred by Commission on excessive pricing of propylene & PPTribunal hearing concluded in 2013, decision pendingSasol arguments on definition of economic valueThe advantage from cheap feedstock is a special advantage that Sasol should retain profits fromHow to assess return on capital – replacement cost, shared costsCommon cause that: Sasol costs of producing PP are lower than almost all other countries while its prices to local customers have been higherNo other policies pursued in meantime (industrial policies, regulatory measures)
35Case study: Gas regulation? Regulation is understood in terms of price and accessPrices are controlled because otherwise they would be set at monopoly levelsRegulation thus seeks to control the rents that accrue as a result of market failuresThese 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 marketThis complicates the role of the regulator as they have to distinguish when it is efficient to allow high profits and when it will retard growthGas Act Identifies stimulating investment and fair and competitive prices as its objectivesRequires the regulator to make choices about which interests to prioritise when taking its decisions
36Legislation 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 timethe 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 pipelinesThe 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 dispensationThe special dispensation period comes to an end on 25 March 2014
37Gas 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); plusthe difference between all the operating costs of the customer’s use of the alternative fuel and all the operating costs of using natural gas; plusthe 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
38There was an additional clause to cap the average prices The purpose was to limit Sasol Gas revenues compared to a benchmarkThe 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 EBPIn the event that it did customers were eligible for refunds from Sasol Gas
39The Gas ActNERSA to set prices for distributors, reticulators and all classes of customers, where there is inadequate competitionrequires non-discrimination prices, tariffs and other conditionsGas 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 tariffsMaximum Prices Methodology, applicable to the price for gas energy (molecule)In February 2012, NERSA determined ‘inadequate competition’ in gas
40Maximum prices as per NERSA (gas energy price) Maximum price based on a weighting of prices of alternative sourcesCoal, diesel, electricity, HFO and LPGWeights 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 benchmarksCoal is the FOB Richards bay priceDiesel is the BFP for dieselElectricity is the Eskom average tariffHFO is the DOE priceLPG is the maximum Refinery Gate Price (Coast)
41Evaluation- 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 EBPIs 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 paShould the EBP comparison be done on a customer category level rather than using average prices?
42Comparing International gas price by consumption category (NUS survey for 4500GJ pa comparable –SA class 3)
43New Dispensation:Weights based on total rather than industry energy consumptionFOB Export coal prices are used rather than ex-mine pricesExport grade coal used rather than grades bought by local industryAverage elec tariff used rather than the industrial tariff (or even megaflex)
44Implications of different benchmark prices Choice of benchmarks mattersThe 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 2011Calculated Maximum gas energy price for 2011 (NERSA data) –R103.40Using 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%
45SA Energy consumption vs Industry consumption Overall consumptionIndustry SectorOverall Consumption (TJ)WeightsIndustry Sector consumption (TJ)Coal75985836.2%46024549.55%Diesel52095224.8%506285.45%Electricity77914037.1%41759544.96%HFO236481.1%3640.02%LPG173230.8%0.00%928833wasIndustry Sector incl:Iron and SteelChemical and PetrochemicalNon-Ferrous MetalsNon-Metallic MineralsTransport EquipmentMachineryMining and QuarryingFood and TobaccoPaper Pulp and PrintWood and Wood ProductsConstructionTextile and LeatherNon-specified (Industry)
46Illustrative exercise (2011) Weights (industry)Price-A (R/GJ)Price-B (R/GJ)Coal49.55%15.473.60Diesel5.45%8.49Electricity44.96%61.7952.61HFO0.04%0.05LPG0%0.00Weighted Maximum100%85.8164.75Price-A: Calculated using benchmarks as stipulated in the methodologyPrice-B: Changed the thermal coal price to FOR and electricity price to industry tariff
47Approved Maximum Piped Gas Price GJ p.aGas Energy Price (GE) - R/GJ forecast 2014Reductions %Reduction (R/GJ)Sasol GE (R/GJ) (26/3/2014)NERSA approved (26/3/2013)Class 1< 4001287.50%9.6R 118RClass 2Class 315.00%19.2R 109RClass 422.50%28.8R 99R 91.21Class 530.00%38.4R 90R 82.38Class 6>37.50%48R 80R 73.56
48Breakdown of impact of price decision by customer Size TotalTotal in %volume% Volume*Small Customers that will/ may face decreases26858%3%Small Customers that may face increases7416%2%#Large Customers that may/will face decreases6614%36%Large Customers that may face increases5712%59%Total customers465100%All Customers facing price decreases72%39%All Customers facing price increase28%61%
49Sasol Gas Turnover and Operating Profit SA Energy: Sasol GasFinancial Year20122011201020092008200720062005TurnoverR m69315445537156664697370232092404Operating profit2985257824792424178519361526931Operating profit margin%43474638524839
50F. Conclusions?Regulatory framework continued to benefit upstream industry for many yearsNow evident in re-assessments of margins, benchmarks usedThe ‘deals’ brokered with the industry under apartheid had a rationale in terms of investment and support for SasolRationales have changed, but implications persist?Continued balance towards investment returns even where new investment is unlikelyGovernment has continued to privilege a particular view of security of supply considerations oriented to insidersInvestment concerns motivated by Sasol appeared to trump stronger interventions (Windfall tax)Industry structured now more skewed to upstream than in 1994Regulatory framework sets ‘rules of the game’, balancing interestsAre the outcomes consistent with required balance?