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 www.uj.ac.za/ccred

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

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

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

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

Net trade: local demand outstripping supply for liquid fuels

Performance: output (VA)

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.

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% 1994-2002) 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

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)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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?

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

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

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): 1994 - 2011 Plastic products: 1.8% Coke & refineries: 6.0% Basic chemicals: 4.9% Other chemicals and man-made fibers: 4.7% 2006 - 2011: 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

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 1971-2004 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

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

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

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

Plastics trade performance: major categories

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)

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

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

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

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

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

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)

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 1 885 000 GJ pa Should the EBP comparison be done on a customer category level rather than using average prices?

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

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)

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%

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% 2100921 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)

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

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 108.86 Class 2 401 - 4 000 Class 3 4 001 - 40 000 15.00% 19.2 R 109 R 100.04 Class 4 40 001 - 400 000 22.50% 28.8 R 99 R 91.21 Class 5 400 001 - 4 000 000 30.00% 38.4 R 90 R 82.38 Class 6 > 4 000 000 37.50% 48 R 80 R 73.56

Breakdown of impact of price decision by customer Size   Total Total in % volume % Volume *Small Customers that will/ may face decreases 268 58% 1 872 400 3% Small Customers that may face increases 74 16% 1 227 600 2% #Large Customers that may/will face decreases 66 14% 22 323 100 36% Large Customers that may face increases 57 12% 36 576 900 59% Total customers 465 100% 62 000 000 All Customers facing price decreases 72% 39% All Customers facing price increase 28% 61%

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

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?