19268 Viewpoint 'MMe No. 179 April IMS Regulation in New Natural Gas Markets- The Northern Ireland Experience Peter Lehbnann So far gas market liberalization has generally occurred in mature markets-particularly where much of the pipeline system has already been laid, as in Argentina, Britain, and the United States. In these cases a competitive structure is appropriate. In new markets, however, it may be difficult to introduce a competitive regime from the outset, and a different approach and form of regulation, such as a period of exclusive licenses, may be needed.' In 1997 the Northern Ireland authorities awarded Phoenix Natural Gas an exclusive license for a limited period to develop a new gas market from scratch in the greater Belfast area. This Note explains the rationale for a period of exclusivity and describes Northern Ireland's approach to gas market regulation. The Northern Ireland authorities hacl been eager The economics of supplying gas to areas outside to develop a natural gas market, both for envi- Belfast are difficult, though better opportunities ronmen-tal reasons and to make the province imiay develop. Indeed, in a ncw gas industry it mtore attractive to foreign investors. Their effort can be argued that the initial development was triggered by the conversion to natural gas of license should be granted only for part of a a power plant in Northlern Ireland, wvith coIll- region or country. In that case it may be best to missioning in 1996. The plant wTas owned by develop the network as a series of regional fran- British Gas (nov BG), and the gas is transportecl clhises. That way. two or more licensees wlill be from Britain by a subsea pipeline. This pipeline well placed to compete in each other's areas provided an opportunity to deliver natural gas to once the industry matures. homes and irdustry. Monopoly in transportation To take up this opportunity, a license for nauiral gas for the greater Belfast area was granted to The authorities accepted British Gas/Phoenix's Phoenix Natural Gas in a tender limited to only argument that a long (twenty-year) transporration one other candidate. Phoenix was originally a 100 monopoly period was needed to attract an percent 5uLbsidiary ofBG, thougl Kevspan Energy investor into the markct. The necessary invest- now has a 24.5 percent shareholding. Phoenix mnents appeared to British Gas/Phoenix to be was granted a combined license for transport and fairly marginal. Major marketing risks stemmed supply, but cliffcrent approachcs were used for from having to displace coal, liquefied petroleuLml the two activities. An exclusive transport license gas. and oil in the residential market and from the lasts twenty years, but competition in supply wrill dependence of Phoenix on the decisions of a be allowed after only two to eight years. single body, the Northern Ireland Housing Executive, the public housing authority that owns Northern Ireland contains 600000 householdls. more than a quarter of the houses in greater with just over 250,000 in the greater Belfast area. Belfast. There were also substantial technical and T The World Bank Group * Finance, Private Sector, and Infrastructure Network Regulation in New Natural Gas Markets-The Northern Ireland Experience financial risks. The autlhorities decided that all If Phoenix does not meet its obligations, it will these risks would be compounded if multiple lose its exclusive license in the districts where it infrastructture licenses were granted. fails. Thuls other companies couldl then he granted transportation licenses. Thle autlhorities also agreed with British Gas/ Phoenix that a single license wouldl have other Transportation charges advantages. A single cleveloper is inore likely to clevelop an optimal, well-designed "backbone" From the outset P'hoenix has maintainecd separate network (avoiding, for example, multiple pipes charges for the use of tlhe transport network hy and wires running down the same street). And a gas suppliers and for the supply of gas to final single developer is easier to deal with in terms customers. Until competition is introdtuced, the of granting approvals, planning traffic, making transport charge will simply he a transfer price contingency plans, and providing local authlority between Phoenix's distribution ancd sIpply support services. btusinesses. Development obligations Both Phoenix and the authorities recognized that the price to final customers wxouldl have to he One of the authorities' primary goals was to kept lowv for many years to persuade ctistomers secure the construction of an extensive natural to switch to gas and that the overall costs of sUp- gas pipeline system in Belfast. Thtis investment plying gas wouIld be dominated by the transport obligations were a key part of the license. Several charges. Thus the debate over pricing focuLsed on challenges arise when an investment program is the transport charges; the supply prices were less expected of an exclusive licensee: how to ensure contentious. that the investment takes place, what sanctions to put in place if it does not, and how to deal Standard approaches to setting transport witlh unforeseen circumstances. charges are not appropriate for a new industry. The regulatory asset base starts fromii zero, The license requires Phoenix to complete its net- changes rapidly, and is Unpredictable. If charges work in twelve years and to perform the wxork in are based on a return on assets, they wxould he each of Belfast's twelve districts in a specific order, exceptionally high at the outset (because of low withlin a specified timeframe. Moreover, a pipeline utilization) and would change sharply fi-om year must nLn *xithin 50 meters of 90 percent of the to ycar. Thus it was decided to set transport homes in each clistrict. This was a much more charges at a level that is expected to provicle an cletailed blueprint than Plhoenix would have liked. 8.5 percent real pretax return on cash flows over Phloenix argued that it already hacl major sunk txxernty years, with calculations based on fore- investments-in medium- and high-pressure cast capital and operating costs, sales levels, and pipelines-and so hacd the necessary' commercial mix of sales. Phoenix consideredi this return incentives to connect up the maximum load. The rather low given the risks involved in the detailed blueprint created a risk that Phoenix will project. But there was some upside from the fail to meet its obligations. TWo safegtiards for prospect of acdditional transport revenue after Plhoenix redluce but do not eliminate the risk: the initial txventy-year license period. The big * The regulator can agree to changes in the qcuestion mark was the enormous uncertainty order and dates of pipeline construction if about all the forecasts. To address this uncer- there are good reasons for doing so. tainty, it was agreed that there would be a * Plhoenix does not have to lay pipes past hous- reforecast every five years, with one possible ing that the Northern Ireland Housing Executive additional forecast in the initial five-year period. hacl not converted to. and does not intencl to Uncler these reforecasts the previous five years convert to, natural gas. will be "'water tinder the bridge"-that is, Phoenix wvill retain any gains and bear any The scope for competition may be limited given losses if developments differ from what vas the small or nonexistent margins betwZeen trans- forecast. Thus there are incentives for efficient port and supply charges for many years. Still, and rapid market development. However, prices Phoenix wanted an initial exclusivity period. The for the remaining period of the license wouild be company was concerned that potential competi- adjusted in light of changes in the forecasts so tors would protest and that the authorities would that the net present value over the remaining take action if competition did not develop wlhen period, given the new forecasts, would be the it was permitted on paper. In the end the exclu- same as in the original net present value sivity periods agreed on were quite short-partly calculations. because the rest of the United Kingdom has com petitive gas markets. One of the most controversial issues in the nego- tiations over transport charges was how to deal Prices to final customers with changes in the distribution of gas sales among market segments and wvith the effects of A key challenge for the new gas industry is to such changes on costs and average prices. In win customers who are using competing fuels. addressing these matters the authorities wantcdl The gas industry sometimes argues that it needs to prevent excessive profits for Phoenix, but also neither regulation nor gas-to-gas competition to provide incentives for rapid development of because there is strong competition between the network and market. fuels. In a mature market vith many gas cus- tomers, interfuel competition may need to be Competition in supply supplemented, especially in the residential mar- ket. But where a gas industry is being estab- In a mature utility industry it is generally desir- lished, the industrv's argument is valid. able to separate the transport business and the supply business, as there is different scope for Thus in Northern Ireland there is no regulation competition and different competitors in the twxo of gas prices to consumers, other than rules bar- sectors. In a developing industry, however, too ring discrimination, for the first five years of the strict a separation is undesirable. For example. license. After that the regulator can introduce a the transport arm and the supply arm should price formula if he decides that customers' inter- plan an integrated rollout of the network to avoid csts are not adequately protected by competition major cost inefficiencies. That process involves between fuels or within the gas market. This reg- information sharing and cooperation that might ulation applies only to consumers using less than be unacceptable in a mature industry. Moreover, 2.2 million kilowatt-hours a year; larger industrial the cost allocations between infrastructure and customers are not subject to regulation of final marketing are blurred in the early days of a new prices. industry. The license sets out extremely broad principles Phoenix will face competition in supply in domes- for determining prices to customers if and when tic and small industry markets (less than 2.2 mil- regulation is introduced. Moreover, there is a pro- lion kilowatt-hours a year) in late 2004. Given that vision for a ruling by the Monopolies and Mergers customers are being connected gradually over the Commission if the regulator and licensee cannot eight-year exclusive license period, the average agree on prices. monopoly supply period for these customers will be four to five years. The monopoly period is Cooperative approach to regulation shorter for larger industrial customers-from twro to three years, with each district opening up to The former regulator for electricity in Northern competition on a rolling basis. Ireland has become the joint gas and electricity Regulation in New Natural Gas Markets-The Northern Ireland Experience regulator. But for several reasons the common than was expected. There has .tlso heen a sholt- adversarial approach to regulation is inappropri- age of appliance retailers and, more important, ate in the new gas market. The uncertainty and qualified installers. pace of change mean that the grounci rles wS;ill clhange rapidly-both sides need to recognize It is still early days. but so far it has heen the mar- this. The lack of an asset hase and the absence ket rather than regulation that has had the m ajor of entrenched" high operating costs will also impact on the dcevelopment of the Northern affect the regulator-'s approach. In any case the Irelanid gas industry. normal regulatory battle-where the regulator wants loxw prices and the company wants higlh Ihis NIL' htu Ibeen pric Wxit i .le p h v (,ol cxroid Luine. (In, profits-wvill likely be replaced in tlhe early years lUrlrrv. ndi Mtiilin i'Inkelt of (vnlr i . I need Kingdoin. hy a major shared objective: both sides want Tie inpaik s, icc wni t h inI pon uids pri hip ruling rapi(l penetration of the market. Furtlhermore, at mg nurkets mognweC his. the initial stages the fledgling industry will he a small or medium-size company and shouldl not PeterLemanan (alllehmann.demon.co.lD, he hurdened Isy unnecessarily hig7h costs of until 1998, Commercial Director' Centrica, funding the regulator's office, staffing a hig reg- now Chairmnan, Enerqy Saving Trtst. t, Cited tulator;' affairs team, ancd funding inquiries from Kinzgdlom the Monopolies ancl Mergers Commission. Viewpoint is an open Conclusion forum intended to oncourage dissemination of and debate on ideas, A lack of good precedents and credible compet- innovations, and best ing offers made negotiations over the gals license practices for expanding unusually difficult in Nortlhern Ireland. For good the private sector The views published are reasons, the approach taken to choosing thie those of the authors and licensee vwas partly hut not fully competitive. In should rot be attributed some circUmstances a more competitive process tc the World Bank or any ol its affiliated organize- might he [letter. Still, the license that emerged tions. Nor do any of the may he useful for anyone vxorking on the regu- conclusions represent lation of newv gas industries. official policy of the World Bank or of its Executive Directors or In the two years since license discussions 'ere the countries they concluded, Phoenix has completed the initial present. clevelopment of its network, meeting all regula- To order additional tory targets and overcoming some inevitable clif- copies please call ficulties. Moreover, Phoenix's gas prices have 202 458 11 11 or contact Suzanne Smith, editor, been lo.er than was anticipated. Room FlItK-208, The World Bank, Still, the maarket has posed some tough challenges. tift H Street, NW, Washington, D.C. 2W3, Competing fuel prices have heen low (especially or Internet address for oil), and threatened competitors, especially in ssmith7@worldbank.org. residential markets, haxve fought back. The North- The serion in a no available on-ine nrn Ireland Housing Executive, which had necdecd (www.worldbank.org/ to demonstrate impartiality hetwveen fuel stuppli html/fpd/notest/ ers, has only recently announcccl that natural gas ® Printed or recycled iS the preferred fuieL. As a result fewer of the exec- paper utive's properties have been refurbished with gas