The Regulatory Framework of the GB Gas Market

Anjli Mehta, Senior Economist, Wholesale Markets26/06/14

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Contents

1. Privatisation and Liberalisation 2. Ofgem Statutory Duties 3. Regulation of Wholesale Markets4. Regulation of Network

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Privatisation and Liberalisation

1. Privatisation and Liberalisation 2. Ofgem Statutory Duties 3. Regulation of Wholesale Markets4. Regulation of Network

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GB gas market 1986 - 2000

Competitionderegulation

Monopoly

Industrial/commercial competition

Network Code – single contract

Domestic competition roll out

New trading market

British Gas demerger – storage and E&P

British Gas privatisation

Time

Transportation (TransCo) separated

1986

1990

1996

1997

1996-98

1999

2000

1995

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Gas Act 1986 Enabled privatisation of British Gas and created regulatory framework.No differentiation between supplier of gas and operator of transmission system.

British Gas only authorised supplier for consumers < 25,000 therms (732 MWh) / year. Competition for consumption > 25,000 therms (732 MWh) / year (“large consumers”)

1988 MMC report Reference to MMC (Monopolies and Mergers Commission) for large consumer market. Concluded many large consumers had no realistic alternatives to British Gas, and evidence of price discrimination. As a result – British Gas required to price by reference to published schedules.

Also undertook to contract for no more than 90% of any new supplies from UK continental shelf in the period June 1989 – May 1991.

1991 OFT review Review for large consumer market. Found 1988 remedies had been ineffective in introducing self-sustaining competition in large consumer market. Particular obstacles – lack of available gas for competing suppliers, British Gas’s monopoly of supply to smaller consumers and position in storage and distribution

British Gas gave series of undertakings – creation of conditions so other suppliers should be able to supply at least 60 % of large consumers by 1995; and separation of transportation and storage activities, with published transparent charges.

Gas release programmes to give competitors access to supplies. Combined with independent production from new fields supported development of competition.

Privatisation and Liberalisation

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1993 MMC report References to MMC on pricing methodology for transportation and storage, and tariff formula for smaller consumers.

Main recommendations for separation of transportation and storage from gas supply, regulation of transportation and storage using RPI-X system and eventual introduction of competition for all consumers.

Removal of remaining supply monopoly on a phased basis 1996-1998

Gas Act 1995 Set out framework for roll-out of domestic competition

Set up licensing regime for gas transporters, suppliers and shippers (and transporters not permitted from holding shippers or suppliers licences)

Led to separation of BG (as transporter and storage operator, plus upstream E&P) and British Gas Trading(as shipper and supplier)

1991 Lowered statutory monopoly to consumers < 2,500 therms (73 MWh) / year.

Further gas release programmes.

British Gas Trading spun-off as Centrica

BG demerged Lattice group (transporter and storage operator)

Storage moved outside Transco “ring-fence”

Lattice group merged with National Grid (Electricity TSO)

2000 - 2005

Privatisation and Liberalisation

Gas industry structure

• Privatised with previous structure fully intact • Lacked competitive pressure • Widely considered a mistake of gas privatisation. Required 3 competition enquiries and

number of years for completive gas market to emerge• Electricity liberalisation introduced more competitive structure from outset –

particularly splitting on transmission assets from generation and supply

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Ofgem Role

1. Privatisation and Liberalisation 2. Ofgem Role3. Regulation of Wholesale Markets4. Regulation of Network

Ofgem Statutory Duties

Office of Gas and Electricity Markets (OFGEM)

Principle Objective: to protect the interests of present and future consumers

Regulation of network

monopoliesPromotion of competition

Other statutory duties

• Support the development of a low carbon economy• Take into account the European dimension of all our activities• Regard to Security of Supply

Regulatory independence

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Hierarchy of Law

• EU Law (including European Network Codes)• GB Primary Legislation (Gas Act 1986, Gas Act

1995, Utilities Act 2000, Energy Acts…)• GB Secondary Legislation • Licences (eg Gas Supplier Licence) • Industry Codes

Gas markets and networks

Low Carbon Transition

Security of supply

Agei

ng a

sset

s Affordability

CCS

European Network Codes

LNG

Renewable gas / Shale gas

Uncertain demand

Decline in domestic production

New Challenges and Responsibilities

Smart Grids

Local generation

Energy efficiency

District heating

Fuel poor

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Independence

• Regulator set up at privatisation – Ofgas. Recognition that shareholders needed confidence that government would not “meddle” in British Gas

• European Third Package formalised independence further - National Regulatory Authority (NRA) – Be independent from any public or private entity and act

independently from any market interest – Take autonomous decisions, independently from any political body in

relation to its functions as the designated NRA – Not seek to take direct instructions from any Government or other

public or private entity when carrying out the regulatory tasks set out in the Directive

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Regulation of Wholesale Markets

1. Privatisation and Liberalisation 2. Ofgem Statutory Duties 3. Regulation of Wholesale Markets4. Regulation of Network

Contractual framework

• Licences (LEGISLATIVE)– Gas transporter licence– Shipper licence– Supplier licence

• Uniform Network Code (UNC) (INDUSTRY/NGG)– Governs relationship between gas transporters and shippers– Provides a level playing field

• Charging statements– Statement of Transmission Transportation Charges– Indicative/confirmed

Gas transporter not allowed to hold shipper / supplier licence

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Producer

Consumer

Transmission (NTS)

Distribution

Xoserve Shipper

Supplier

Financial Flow

Gas Flow

Industry Players

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•Applicant must pass 5 tests set out in the GA/EA

•Tests look at who the applicant has shareholdings or other rights in, who has such rights in the applicant (and their other holdings and appointments) and who is a director or the applicant (and their other holdings and appointments)

Ownership Unbundling (OU)

•Applicant’s transmission system must have belonged to a vertically integrated undertaking (i.e. a corporate group involving transmission and production/supply) (VIU) on 3 September 2009 AND arrangements must guarantee more effective independence of the TSO than the ITO model below

Derogation

•For gas applicants only

•I.e. where the TSO has appointed an independent system operator, who agrees to comply with the requirements of the Third Package Directive on ISOs

•Must be approved by the Commission

Independent System Operator (ISO)

Unbundling modelsUnbundling aims to avoid conflicts of interest and to make sure that transmission system operators ("TSOs") take their decisions independently, ensuring transparency and non-discrimination towards all network users. European legislation defines models for unbundling

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•Only available to interconnector applicants

•Applicant’s transmission system must have belonged to a VIU on 3 September 2009

•Applicant must show how it meets the ring-fencing requirements of the Third Package Directives on areas such as: (i) assets, equipment, staff and identity; (ii) independence of the TSO; (iii) independence of staff and management; (iv) supervisory body; (v) compliance programme and officer; and, (vi) network development and investment

Independent Transmission Operator (ITO)

•Interconnector licensees only

•Applicant holds an exemption (e.g. from third party access) and remains entitled to the benefit of it

•Ground only applies for the duration of the exemption

•If partial exemption, must be ring-fencing in relation to non-exempt capacity

Second and Third Package Exemptions

Unbundling models

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Uniform Network CodeThe legal contract between transporters and shippers, that defines the operation of the gas regime, providing “level playing field”. Key elements are:

Definition of players Capacity (access to the system) Energy balancing (system clearing)

Supply point administration (customer management)

Invoicing and credit

Gas trading Emergency procedures

UNC objectives:• Efficient and economic operation of the pipe-line system

• Coordinated, efficient and economic operation of the combined pipe-line system, and/ or the pipe-line system of one or more other relevant gas transporters

• Efficient discharge of the licensee's obligations

• Securing of effective competition between relevant shippers, between relevant suppliers; and/or between DN operators and relevant shippers.

• Provision of reasonable economic incentives for relevant suppliers to secure that the domestic customer supply security standards… are satisfied as respects the availability of gas to their domestic customers

• Promotion of efficiency in the implementation and administration of the Code

• Compliance with the Regulation and any relevant legally binding decisions of the European Commission and/or the Agency for the Co-operation of Energy Regulators

Storage Regulation

Third party access exemptions

• Minor facility exemptions (majority of storage facilities in GB)

• Large infrastructure exemptions (none)

Default regime

• Negotiated third party access (Rough and Hornsea)

Additional requirements

• Rough Undertakings

Facilitate new investment

Support commercial use

of storage

Promote competition in the

gas market

Main objectives

How do these translate in practice?

LNG Regulation

Third party access exemptions

• Large infrastructure exemptions (all existing facilities: Isle of Grain 1-3, Dragon, South Hook)

Default regime

• Regulated third party access (none at the moment)

Facilitate new investment

Support use of LNG import

capacity

Promote competition in the

gas market

Main objectives

How do these translate in practice?

European Network Codes• The Third Energy Package - aims to

facilitate greater cross-border trade and improve efficiency of wholesale markets in Europe through greater integration and a common set of market rules.

• Why are we doing this? – legal obligation, security of supply, protecting GB and EU consumers

• Progress Made – some price convergence, but more work to be done, i.e. Gas not always flowing to where it is most valued

• Network Codes – developed to formalise rules across Europe, which TSOs are obliged to adhere to, to realise the objectives of the Third Energy Package

Ofgem’s Role• Contribute to development of codes

including leading some of them• Provide advice to government who lead

on legislation• Lead some regional initiative projects

• Implement the codes • Work with relevant bodies – eg ACER etc…

The European Dimension

The EU gas target model

Capacity Allocation

Network Code

Auctions, bundled products

Congestion Management Procedures

Overselling and buyback, use it

or lose it

Gas balancing Network Code

Cash-out, market based

balancing

Interoperability Network

Code

Data exchange

Transmission tariff

structures Network Code

Charging rules, reserve prices

Hub

Hub

Hub H

ub

Hub

Hub

Hub

Hub

Hub

Hub

Hub

2011 gas target model of the Council of European Energy Regulators (non-binding)

Recommendation 1: creating liquid wholesale markets (e.g. creating entry exit zones)

Recommendation 2: Connecting markets (improve efficiency of how markets interact)

Recommendation 3: Investment (e.g. incremental capacity auctions)

Legally binding European legislation

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Regulation of Network

1. Privatisation and Liberalisation 2. Ofgem Statutory Duties 3. Regulation of Wholesale Markets4. Regulation of Network

Incentive regulation• Network companies are engineering, asset based natural monopolies

– Unregulated can increase price and lower quality• A price control is a limit on the amount of revenue that companies can collect

– over the course of the price control period allowed revenues are adjusted by inflation (RPI) and an X factor that represents anticipated efficiency gains (or cost increases)

• Companies are incentivised to beat the regulators’ assumptions– If they do, they keep the benefit until the next price control

• At next control, consumers benefit• Quality measures• Sustainable delivery

Allowed revenues

Company’s actual costs

Lower costs for consumers

First price control review

Second price control review

Y1 Y2 Y3 Y4 Y5

Additional profits for company

RPI-X was not broken but a new “fit for purpose” framework was needed

Improved quality

of service

Increased

Investment

It has delivered significant benefits for consumers:

Networks focused on short term

Limited consideration of innovation and how best to deliver

Potentially limited appetite for risk

Bias for ‘capex’ solutions rather than non-network options

But the framework may have led to:

Networks focused on Ofgem not customers

Limited focus on ‘cross-sectoral’ interactions

‘RPI-X’ regulation of energy networks

Reductions in

network charges

More efficient

financing

Improvements in

operating efficiency

We have used RPI-X as a basis for regulating energy networks for about 20 years

Constraint set up front to ensure:

Revenue

Deliver outputs efficiently over time with:Incentives

Technical and commercial innovation encouraged through:

Innovation

Outputs set out in clear ‘compact’, reflecting expectations of current and future consumers

Outputs

=

+

+

Timely and efficient delivery

Network companies are

financeable

Transparency and

predictability

Balance between costs faced by current and

future consumers

8 yr control Rewards/penalties for delivery Upfront efficiency rate

Core price control incentives

Option to give third parties a greater role in delivery

Innovation stimulus package

RIIO: A new approach to regulation

Key elements of RIIO

Comprehensive customer focused outputs

Developed with

customers influence at

all stagesFocus on sustainable delivery and longer term value for money

Network Company allowed and encouraged to take more initiative

8 year control Business plan sets 8 years in longer context

8 year control

Well justified business plan rewarded during setting of price control and

beyond

Company leads justification for efficient plan – makes case for

regulatory review

Retains successful features of incentive regulation – upfront incentives/sharing investment costs between current and future consumers through the regulatory asset value approach – efficient

approach to financing costs

Supports innovation though with additional

mechanisms