Australia- ACCC East Coast Gas Report: Now That the Dust Has Settled, What Does It All Mean?

6 June, 2016

 

What lies ahead for gas projects, producers and users 

 

What you need to know

 

The Australian Competition & Consumer Commission's (ACCC's) report on its inquiry into the east coast gas market has made a mixed bag of recommendations – in some cases it has supported no or less restrictive regulation, and in others it has recommended more extensive regulation. The report is the latest example of the ACCC's intense focus on issues regarding regulation of monopoly infrastructure, and their recommendations on pipeline regulation will continue the ongoing debate around the use and regulation of market power. 

 

In particular:

 

• The ACCC has made a number of findings about the change in structure and conduct of the east coast gas sector following the development of the three liquefied natural gas (LNG) projects in Queensland. These include the domestic market now bring more exposed to international oil prices, and that industrial gas customers have experienced higher and more volatile gas prices under tighter and shorter gas supply agreements (GSAs).
• First and foremost, the ACCC's recommendations tackle the issue of uncertainty surrounding gas supply:
  • The ACCC has called for a change in State and Territory regulation of new gas projects, including a move away from imposing moratoria on exploration and development, and towards a case by case analysis of potential projects. The ACCC considers that moratoria and regulatory restrictions are one of three key factors contributing to uncertainty about future east coast gas supply (along with demand from the LNG projects and low international oil prices), and its recommendation seeks to address this risk.
  • However, the ACCC has recommended that domestic gas reservation policies not be introduced on the east coast on the basis the benefits of any short term decrease in gas prices from such policies are likely to be offset by a reduction in future gas developments. This is a welcome recommendation and should hopefully put this issue to bed – at least for the time being.
• The ACCC has also considered and made observations on the conduct of particular market participants:
  • The ACCC has identified conduct involving pipeline operators (both regulated and unregulated) lawfully taking advantage of their monopoly position by engaging in monopoly pricing. The ACCC has not identified instances of major pipeline operators withholding pipeline capacity, and has found that pipeline operators have responded to changing market conditions by investing in new capacity.
  • However the ACCC has identified examples of possible capacity withholding on certain regional pipelines, and has set itself the task of considering whether this conduct raises competition law concerns. The ACCC has also identified that it intends to consider the competitive effect of joint marketing arrangements used by the Gippsland Basin Joint Venture (GBJV).
• The ACCC has recommended several regulatory measures to address concerns about east coast gas competition: o A substantial and radical increase in the economic regulation of gas pipelines to tackle what the ACCC views as significant monopoly pricing by both regulated and unregulated pipelines;
  • Reforms to increase transparency, including reporting of information about reserves and gas prices (both an LNG "netback" price and potentially prices under domestic gas contracts); and
  • Monitoring by the Council of Australian Governments (COAG) Energy Council of emerging issues regarding the separate, narrower gas specifications required to be met by gas entering infrastructure associated with the Queensland LNG projects – the ACCC considers that costs associated with non-standard gas specifications should be borne by the market participants requiring that specification (ie Queensland LNG producers). 

 

What next? 

 

• The ACCC's recommendations place considerable faith in the power of regulation to deal with structural and behavioural market issues. The report is likely to further embolden the Australian Energy Market Commission (AEMC) to pursue an ambitious reform agenda in Stage 2 of its own East Coast Wholesale Gas Market and Pipeline Frameworks Review, which has been unfolding in tandem with the ACCC's inquiry (AEMC Review). The AEMC's Draft Report1 has already called for significant changes to matters such as trading of pipeline and hub capacity and information disclosure, and the AEMC has deliberately timed its final report to follow this report by the ACCC.
• While the industry has generally supported any measures that would remove regulatory barriers to new gas projects, a number of pipeline operators have rejected the ACCC's recommendations about further regulation of gas transmission pipelines.
• The Commonwealth Minister for Resources, Energy and Northern Australia, Josh Frydenberg, has supported three aspects of the ACCC report: the recommendations against a domestic gas reservation policy, the proposed changes to the economic regulation of pipelines to address concerns about monopoly pricing, and the additional reporting obligations aimed at increasing information transparency.2

 

What next? 

 

The inquiry

 

Background

 

The inquiry was started by the Minister for Small Business on 8 April 2015, who tasked the ACCC with inquiring "into the competitiveness of wholesale gas prices and the structure of the upstream, processing, transportation, storage and marketing segments of the gas industry" under section 95H of the Competition and Consumer Act 2010 (Cth). Since then, the ACCC has held two public hearings, 30 private hearings, consulted with over 50 interested parties, and collected 73,000 documents (including through the use of its compulsory powers).

 

Why this inquiry matters

 

This inquiry could be a watershed moment in the regulation of wholesale gas markets, heralding a move away from "light touch" regulation, and in favour of more extensive and intensive regulation of pipeline infrastructure. The report follows the footsteps of the government’s response to the Harper Review (which foreshadowed broader changes to price and access regulation), and it coincides with the AEMC Review. We expect that the AEMC will use this report as support for its own complementary and supporting recommendations. The recommendations in the report are also further evidence of ACCC's approach to advocating regulation of monopoly infrastructure (for further reading, see our comments on infrastructure regulation in The Ashurst View: 2016 in Competition Law).

 

Findings about the east coast gas market

 

Permanent changes to the domestic gas market

 

The ACCC has found that the domestic gas market has been irrevocably changed following the development of the three LNG projects in Queensland. It has suggested that the development of those projects has resulted in:

 

•   a shift in gas flows to Wallumbilla, so that gas can be sold to LNG producers for export rather than being sold to industrial customers, as reflected by the GLNG, QCLNG and APLNG LNG joint ventures now accounting for a substantial proportion of total east coast gas demand (by way of illustration, east coast gas demand is estimated to rise from 700 PJ per annum in 2014 prior to LNG export to between 1,750-2,200 PJ per annum once all six Queensland LNG trains reach full production in 2017-18);
•   the domestic gas market becoming increasingly exposed to international oil prices; and
•   an increase in the significance of the GBJV as the primary supplier of domestic gas to the southern gas markets. 

 

The ACCC has found these changes have made it more difficult for industrial gas customers to secure long term supplies of gas and has led to both higher, and more volatile, gas prices. The ACCC concluded these problems have been exacerbated by:

 

•   both regulated and unregulated pipelines charging monopoly prices for services, which the ACCC is concerned may be leading to inefficiencies in gas consumption and use;
•   State and Territory regulations (particularly moratoria on exploration and development of unconventional gas reserves) inhibiting the development of new sources of gas supply; and
•   information asymmetries making it difficult to negotiate both GSAs and gas transportation agreements (GTAs). Gas pricing

 

The ACCC has found, in this environment, gas producers have kept one eye firmly on the international market when negotiating GSAs with domestic gas customers. As a result, pricing has become both more volatile as LNG pricing is ordinarily linked to the

international oil price, which has fed through to domestic gas pricing. This is despite the ACCC finding that most GSAs it reviewed used a price adjustment formula that was not linked to the oil price. At the same time, the ACCC has found that GTAs have become more expensive, and the negotiating environment generally has been made harder by a lack of transparency about available gas, future sources of gas supply, and gas pricing generally.

 

The ACCC considers that the Queensland LNG projects have created different (but interrelated) market dynamics between the domestic gas markets in Queensland and the southern states. As Queensland gas producers have supplied LNG producers, and as production from the Otway and Bass basins has declined, industrial and commercial customers in the southern states have become increasingly reliant on gas produced by the GBJV.

 

The ACCC has found that, in the absence of a widely accepted external reference price in the east coast gas market, prices paid by industrial customers and retailers under GSAs have been determined by bilateral negotiations. The LNG projects have impacted on the alternatives available to both gas producers and customers, as gas producers now have the option to sell gas for export. The ACCC argues that this means:

 

•   in a competitive market, domestic gas prices should trend towards the seller's next best alternative price, which is likely to be the price those producers could sell to LNG producers minus transportation costs; and
•   in a non-competitive market, domestic gas prices should trend towards the buyer's next best alternative price, which is likely to be the price of gas sold by Queensland producers at Wallumbilla plus transport costs.

 

Importantly, under this analysis the gap between the buyer's and seller's best alternatives is shaped by the transport costs between Wallumbilla and the buyer's location. This has led the ACCC to focus on the cost and availability of pipeline transportation, as the ACCC expressed the view that monopoly pricing by pipeline operators could exacerbate the pricing outcomes for domestic users, particularly in a non-competitive market The ACCC's concerns about the competitiveness of the gas market has also led it to question whether joint marketing by the GBJV remains in the public interest. 

 

Pipeline services

 

The ACCC recognised that pipeline operators have responded to demand with investment in new pipelines (including the proposed investment to develop the new Northern Gas Pipeline (NGP) that will link the Northern Territory with Queensland), and a number of pipeline expansions. However, the ACCC has concluded that both regulated and unregulated pipelines have exercised monopoly power by implementing monopoly pricing.

 

As evidence of this, the ACCC pointed to pricing of "as available", "interruptible" and "forward haul" services that are 2 to 5 times higher than regulated prices, and financial returns that are 1.4 to 20 times higher than the benchmark return on equity that the Australian Energy Regulator (AER) determined over the last three years (with returns between 6% to 159%, compared to AER determined returns ranging from 7.1% to 8%). It appears these higher returns may have been the result of some pipelines having already recovered the cost of construction (without substantially reducing pricing), and some pipelines seeking to recover their capital investment over the life of foundation GTAs rather than the pipeline's economic life, in order to reduce risk.

 

While those higher returns are likely to have been a significant factor in attracting new investment in pipelines, the ACCC has observed that the forecast returns on the proposed NGP are significantly lower than some of the returns it has observed in the market. As explained below, pipeline regulation is therefore a significant focus area for the report.

 

However, while the ACCC has expressed concern about monopoly pricing, it did not find evidence that pipeline operators were withholding capacity from the market (except in the case of some isolated regional pipelines).

 

AEMC review

 

The AEMC Draft Report set out a proposed roadmap for the development of the east coast gas market, which included recommendations to:

 

•   redesign wholesale gas trading markets, including by concentrating trading at a northern (Wallumbilla) and southern (Victorian Declared Wholesale Gas Market) supply hub;
•   facilitate access to pipeline capacity, by introducing capacity trading platforms and a day-ahead auction system which could potentially also apply to hub services (see discussion below); and
•   enhance information provided through the Gas Market Bulletin Board.

 

The AEMC Review is in its final stages, and its final report is scheduled to be provided to COAG in May 2016, with this

timing deliberately intended to occur after the ACCC's report.

 

ACCC Proposals for reform

 

"Drill baby drill"?

 

The ACCC is particularly concerned about the development of new sources of gas supply and sees this as a key solution to the problems in the east coast gas market. The ACCC has strongly encouraged the States and Territories to be more circumspect about regulating new gas developments and has called for an end to development moratoria, so that developments can be considered on a case by case basis. While it made this criticism generally, it did emphasise the moratoria and other regulatory restrictions in New South Wales, Victoria and Tasmania as preventing or impeding onshore gas exploration and development, and the potential moratorium on fracking in the Northern Territory.

 

More pipelines regulated, and more pipeline regulation

 

The ACCC places little stock in the effectiveness of the National Gas Law.

 

The report took particular aim at the current access regime for gas pipelines under the National Gas Law. It found:

 

•   the existing "coverage criteria" meant that few pipelines are regulated by the National Gas Law, and that the threat of regulation is a very low incentive to prevent monopoly pricing (with only 5.5 transmission pipelines regulated, 3 under full regulation and the rest under light regulation, out of approximately 30 transmission pipelines); and
•   even regulated pipelines are able to exercise monopoly power through monopoly pricing of pipeline expansions, and through pricing of pipeline services that are not regulated "reference services".3 

 

The problem with the coverage criteria

 

The ACCC found that the existing pipeline coverage criteria, which determine when a pipeline will be regulated under the National Gas Law, are not suited for dealing with monopoly pricing. This is because one of the key coverage criteria which must be satisfied in order for a pipeline to be regulated tests whether access (or increased access) would promote a material increase in competition in at least one market (whether or not in Australia) other than the market for pipeline services provided by that pipeline. The ACCC suggested this criterion is unlikely to be satisfied in the case of gas pipelines because:

 

•   pipeline operators are generally pure play rather than vertically-integrated, which means they have limited or no incentive to reduce the sale of pipeline services to obtain a strategic advantage for their related operations in upstream or downstream markets (by contrast, a vertically-integrated pipeline operator may have an incentive to discriminate in favour of its own downstream operations); and
•   the downstream LNG and domestic gas markets are already competitive, making it difficult to identify any potential material increase in competition that would result from pipeline regulation (even if there is evidence that an unregulated pipeline is more likely to engage in monopoly pricing).

 

In short, the ACCC has formed the view that the existing coverage criteria do not deal with the "market failure" it identified as evidenced by monopoly pricing for pipeline services. To remedy this, the ACCC suggested that a new model should be implemented which "breaks the nexus" between the National Gas Law and the National Access Regime (contained in Part IIIA of the Competition and Consumer Act 2010 (Cth): for more information about the National Access Regime see our Competition Law News National Access Regime stays out of the Port of Newcastle).

 

The report suggests the new model should be refocussed on efficiency, rather than promoting competition. This reflects the ACCC's view that "the problem with using competition as a proxy for efficiency is that competition and efficiency are not synonymous". This indicates there may be an efficiency problem to be solved by regulation, even if there is no competition problem to be solved by regulation.

 

The ACCC has recommended that the COAG Energy Council should agree to replace the current coverage test with a new test, which would be triggered if the relevant Minister, having regard to a recommendation by National Competition Council, is satisfied that:

 

•   the pipeline has substantial market power;
•   it is likely the pipeline will to continue to have substantial market power in the medium term; and
•   coverage will, or is likely to, contribute to the achievement of the National Gas Objective to "promote efficient investment in, and efficient operation and use of natural gas services for the long term interest of consumers of natural gas with respect to price, quality, safety, reliability and security of supply of natural gas".

 

The ACCC has also recommended that the COAG Energy Council ask the AEMC carry out further consultation on the specific matters that should be considered when applying this test, how it should be implemented, and to advise the COAG Energy Council on the necessary amendments to the National Gas Law and National Gas Rules.

 

This puts the focus of the coverage test on market power and economic efficiency, rather than on whether regulation through coverage will promote competition in any dependent markets. The ACCC's proposal is a significant departure from the approach agreed by the COAG in the Competition Principles Agreement (which effectively sets out the agreed ground rules for developing third party access legislation throughout Australia). This is because one of the central planks to the third party access regulation under the Competition Principles Agreement is that access regulation should only be applied where it is likely to promote competition in upstream or downstream markets, and not otherwise to pursue efficiency objectives.

 

Ex ante price regulation beyond reference services

 

The ACCC has suggested that the "negotiate – arbitrate" model in the National Gas Law does not sufficiently curtail pipeline operators' legitimate commercial incentives to engage in monopoly pricing, particularly for pipeline services that are not regulated (even if those services are provided on otherwise regulated pipelines). It reasons that this is because:

 

•   the threat of arbitration is too remote, as the complexity and time involved to pursue an arbitration makes it unattractive for access seekers; and
•   information asymmetries make it difficult for an access seeker to determine whether prices on offer are cost reflective, which in turn means they are unable to properly assess the merits of pursuing arbitration.

 

However, the ACCC has not presented any concrete solutions to this issue. Instead, it has recommended that the AEMC undertake consultation on this issue. It may be that some of these concerns could be alleviated by amending the regime under the National Gas Law to increase information transparency (to improve the bargaining position of access seekers), and streamline the dispute resolution system (which currently calls for private arbitration by the ACCC).

 

The ACCC also criticised the fact that pipeline extensions of regulated pipelines are not automatically regulated (except in the Victorian Declared Wholesale Gas Market, which operates a market carriage, rather than contract carriage, model for transmission pipelines4).

 

Greater secondary pipeline capacity trading, but without a compulsory auction

 

The benefits of secondary trading of pipeline capacity have been recognised by the ACCC and the AEMC. In late 2015, the AEMC proposed an auction process involving a:

 

•   voluntary capacity trading platform for shippers to trade secondary capacity anonymously prior to a "cut off"; and
•   compulsory day-ahead auction for "contracted but un-nominated" pipeline capacity triggered after "cut off".

 

This would, in substance, extend the reach of access regulation into already negotiated GTAs on regulated pipelines, and GTAs on unregulated pipelines. Interestingly, while the ACCC supports greater secondary capacity trading, its report falls short of supporting the AEMC's proposal. It instead advocates the development of a centralised trading platform to facilitate secondary capacity trading, and the use of standardised capacity trading provisions in GTAs. It has also asked the AEMC to consider the benefits of a short-term auction process for hub services if it decides to implement a day-ahead auction for pipeline services, but otherwise has not endorsed the proposals the AEMC is considering. 

 

Improving competitive bargaining through more transparency

 

The ACCC has identified a lack of information about gas and transport prices, gas availability, and concerns about future gas availability as key impediments to competition. While gas trading hubs are useful, the ACCC views the existing short term trading markets and declared wholesale gas markets as, in effect, balancing markets rather than useful price discovery tools. To that end, the ACCC has recommended measures to ensure greater market transparency, including by recommending that:

 

•   the AEMC explore ways to require greater financial information disclosure by all "open access" pipelines (whether regulated or not) to show whether pipeline charges are cost reflective;
•   there be standardised, and greater, reporting of gas reserves based on common price assumptions through the Gas Market Bulletin Board, which would apply across the industry (i.e. not solely to listed companies); and
•   the Australian Energy Market Operator (AEMO) publish gas pricing information, including a monthly LNG netback price to Wallumbilla, and consider the potential development of a periodic price series of actual gas prices. It has suggested the price series might constitute an east coast volume-weighted average price, or a separate price for gas produced in each of Victoria and Queensland, for agreements for the supply of gas by producers which have:
  • a take or pay percentage of 80-85% and a load factor of 110-130%; and o a take or pay percentage of 90-95% and a load factor of 110-130%.

 

However, the ACCC has recommended that the AEMC consult with gas buyers to ensure that any such price series published by AEMO would deliver sufficient benefits to justify the cost if implemented.

 

Gas specifications

 

The ACCC also pointed to an emerging potential issue relating to gas specifications, which it says could result in a "bifurcated" domestic east coast gas market. The issue arises because the specifications gas needs to meet in order to be used by the Queensland LNG projects are narrower than the general specifications required for domestic gas use. The ACCC is concerned that it is more costly to ensure that gas meets the narrower specification, and that this has a potential cost impact on domestic gas users, and may be a disincentive for new gas producers to explore and develop gas projects in some areas outside Queensland. It also commented that gas producers seeking to supply gas to the Queensland LNG projects may mean that the gas may require processing by the Moomba Processing Hub (MPH) in order to meet the relevant specifications. The ACCC has expressed concern that this may place the MPH in an increasingly important position in the east coast gas sector, potentially giving it significant pricing power. As a result, the ACCC has called for COAG to monitor the situation to ensure that market participants who require gas to meet specific gas specifications (i.e. specifications that are different to the standard typically required for domestic gas use) bear the associated costs.

 

A warning bell for joint marketing?

 

The ACCC has flagged that it will reconsider the competitive effect of joint marketing arrangements of the GBJV, on the basis that it is concerned that the GBJV's market power is now "significantly stronger" than it was when the ACCC last considered the matter in 2010. While the ACCC did stress that it would need to consider the impact on future development of the Gippsland Basin, it also suggested there might be ways to do this that would allow joint marketing to end. 

 

What lies ahead?

 

The ACCC's recommendations against gas reservation policies, and in favour of case by case review rather than exploration and development moratoria, should be welcomed. They respond in a considered way to the extensive policy debate on these topics to date.

 

The ACCC's recommendations on pipeline regulation are unsurprising, but more controversial. It acknowledges that increased gas supply and market participation will solve many of the supply and pricing issues currently faced by industrial and commercial gas customers. However it clearly also places significant faith in the capacity of economic regulation to address shortcomings in competition, and promote economic efficiency.

 

This is a consistent theme from the ACCC, which has strongly advocated that monopoly infrastructure should be subject to appropriate (and often stronger-than-at-present) regulation. The reforms it proposes are a radical change to prevailing orthodoxy regarding infrastructure access regulation, and would increase the coverage of, and regulatory intervention associated with, access and price regulation under the National Gas Law. These recommendations, and their focus on concerns about "market power", continue the regulator's focus on related issues, including in relation to the proposed "effects test" that the Commonwealth Government proposes to introduce to the prohibition on misuse of market power under the Competition and Consumer Act.

 

Significantly, the report suggests much further work for COAG and the AEMC. Industry should closely follow developments from both bodies, including when the AEMC issues its final report on east coast wholesale gas market and pipeline frameworks (which is due later in May 2016).

 

Finally, the way the ACCC has carried out the wide-ranging industry engagement associated with this inquiry may provide some insight into the way it may conduct "market studies" in future, following the Commonwealth government's recommendation in response to the Harper Review that the ACCC retain this function. 

 

1  AEMC, "Stage 2 Draft Report: East Coast Wholesale Gas Market and Pipeline Frameworks Review" (4 December 2015).

2  The Hon Josh Frydenberg MP, "Time to Reform Australia's Gas Market", the Australian Financial Review (26 April 2016). 

3 A "reference service" is a service sought by a significant portion of the market. Under the National Gas Law, a fully regulated pipeline must identify the "reference services", and a corresponding "reference tariff", in its access agreement, which is approved by the Australian Energy Regulator. 

4 Under contract carriage, pipeline operators and access seekers enter into bilateral GTAs and reserve physical capacity. Under market carriage, the pipeline owner makes its system available to an independent system operator (being the Australian Energy Market Operator, in Victoria), who manages pipeline capacity through a pool. 

 

For further information, please contact:

 

Bill Reid, Partner, Ashurst

bill.reid@ashurst.com