1 Ka-fu Wong University of Hong Kong Why were more LPG pumps reported broken at the designated pump stations when the world price of LPG went up?

2 Cleaning the air Pollution had become a major concern in Hong Kong and while little could be done about factories across the border, actions were taken at home. In his 1999 policy address Hong Kong chief executive Tung Chee Hwa announced measures to tackle the territory’s deteriorating air quality. A 1998 trial of 30 Hong Kong LPG taxis found that they performed comparably well to diesel taxis, cost about the same to maintain, emitted “extremely low emissions” and were “virtually free of smoke”. Crucial factors to consider were the effect of fuel price on operating cost and the sufficient availability of filling stations and maintenance shops. Encouraged by the results, the government set out to convert the territories diesel powered taxicab fleet. Efforts were made to ease the transition with incentives offered to owners, drivers and fuel suppliers.

3 Incentives offered to owners, drivers and fuel suppliers To encourage the switch from diesel to LPG, the import of new diesel taxicabs was banned and taxi owners were offered HK$40,000 each for the purchase of new LPG vehicles. All oil and gas firms were welcomed to submit bids to “design, build, and operate” filling stations selling only LPG priced according to a government designed and implemented pricing mechanism. In exchange for signing a 21-year contract to sell at or below capped prices, companies received development land at zero cost. These “dedicated station” contracts were awarded based on the lowest operating price. No duties were levied on LPG sales.

4 The pricing formula at dedicated filling stations the formula (P = A + B) was comprised of the LPG international price (A) and a LPG operating price (B). Ceiling prices were set based on the international free-on-board price – updated once every six months – with additions made for operating costs and profit margins. Determined by the operators when they tendered their original station contract bids, the LPG operating price “operating cost and profit margin” component was updated once a year in-line with the composite consumer price index. Free-on-board : “FOB prices exclude all insurance and freight charges…effectively priced at the loading port” (platts.com). The Saudi Aramco LPG contract price was commonly quoted for trade in Asia.

5 Changes in LPG prices

6 Between the revisions, the LPG prices at dedicated pump stations are fixed – regardless of the world LPG prices. Supply Demand Price Quantity A C D Usually at this regulated price, there will be excess demand (i.e., quantity demanded > quantity supplied). Buyers will line up for the product. Thus, buyers wind up paying with waiting time. Price regulation (ceiling) Excess demand Dedicated stations are willing to supply this quantity only.

7 Broken nozzles When world LPG prices are rising, dedicated stations are not willing to supply – for each unit they supply, they could be losing money. That is, the revenue cannot even cover the variable cost. The firms’ best decision is to shut down the stations. Can the stations be shut down? No. Because the dedicated stations are given a subsidy in land lease, and they are under a service contract to supply LPG. What could be better if the nozzles were broken?

8 Broken nozzles When world LPG prices are rising, dedicated stations are not willing to supply – for each unit they supply, they could be losing money. That is, the revenue cannot even cover the variable cost. The firms’ best decision is to shut down the stations. Can the stations be shut down? No. Because the dedicated stations are given a subsidy in land lease, and they are under a service contract to supply LPG. What could be better if the nozzles were broken?

9 Broken nozzles In December 2005 the average LPG price at the pump at non-dedicated stations was HK$3.27 per liter compared to HK$2.57 per liter at dedicated stations. Thus, the dedicated stations are likely making a loss on every additional liter of LPG sold. During the same time taxi drivers complained of long lines and even “broken pump nozzles”. From January to September 2005 the government received only 1 complaint regarding queuing at dedicated filling stations. After a “hotline’ was established in late November, complaints peaked at 306 in December.

10 Should we have a more frequent price update? At its five year review, the pricing mechanism for “dedicated LPG” was modified to update the international LPG price component once a month as opposed to twice a year. The thought of more frequent price adjustments upset some in the taxi trade. One transport union official complained that since dedicated filling stations received land premium-free, they “should bear the fluctuation of fuel prices and not put the pressure on us.” Will a firm consider the cost of land when making a decision to shut down or not (or more broken nozzles or not)? Land cost is a fixed cost, not variable cost!!

11 What will happen if the LPG prices are falling abruptly? Supply Demand Price Quantity A C D Usually at this regulated price, there will be excess supply (i.e., quantity demanded < quantity supplied). Suppliers will compete for buyers, offering additional attractions. Price regulation (floor) Excess supply Dedicated stations are willing to supply this quantity.

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