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State, National and International Regulatory Regimes

K Peter KolfDirector

KPK Specialist Advisory Services Pty Ltd

Oil and Gas Markets 660Curtin Graduate School of Business26 July 2010

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This presentation has been made available in good faith by KPK Specialist Advisory Service Pty Ltd (KPKSAS). This presentation is not a substitute for professional advice. No person or organisation should act on the basis of any matter contained in this document without obtaining appropriate professional advice.

KPKSAS or its staff make no representation or warranty, expressed or implied, as to the accuracy, completeness, reasonableness or reliability of the information contained in this document, and accept no liability, jointly or severally, for any loss or expense of any nature whatsoever (including consequential loss) arising directly or indirectly from any making available of this document, or the inclusion in it or omission from it of any material, or anything done or not done in reliance on it, including in all cases, without limitation, loss due in whole or part to the negligence of KPKSAS and its employees. This notice has effect subject to the Trade Practices Act 1974 (Cwlth) and the Fair Trading Act 1987 (WA), if applicable, and to the fullest extent permitted by law.

Any summaries of legislation, regulations or codes in this presentation do not contain all material terms of those laws or obligations. No attempt has been made in the summaries, definitions or other material to exhaustively identify and describe the rights, obligations and liabilities of any person under those laws or provisions.

Disclaimer

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OverviewPart 1

• Background on KPK

• About regulation

• About economics

Part 2

• Economics and Law

• Issues in regulation relevant to oil and gaso Project Discovery, Ofgem, UK o Inquiry into domestic gas prices

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Background on KPK• Currently:

‒ Director, KPK Specialist Advisory Services Pty Ltd

• Previously:‒ CEO, Economic Regulation Authority WA

‒ Executive Director, Office of Gas Access Regulation WA

‒ Senior Manager, Strategic Issues, Office of Energy WA

‒ Director, Independent Air Fares Committee Cwth

‒ Manager, Market Economics & Pricing Policy, Telecom Australia HQ Melb

‒ Principal Research Officer, Dept of Minerals & Energy Cwth

Part 1

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What is Regulation?

• A law, regulation, rule, code or policy‒ (with or without the coercive power of the law)

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Examples of Regulation• Safety regulation

‒ Health, safety and welfare regulation

• Technical regulation‒ Electricity rules, communications rules etc

• Social regulation‒ Criminal law, anti-discrimination, freedom of

information etc

• Economic & commercial regulation‒ Monopolies, financial institutions, trade practices etc

• Environmental regulation

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Types of Regulation• Public ownership and control

‒ State Energy Commission (owner, operator and rule maker)

• Prescriptive ‒ Prohibition, setting of limits, price control

• Market Based Regulation (Incentive)‒ Open access, structural separation, synthetic

markets, price or revenue cap regulation

• Light handed regulation‒ Transparency, monitoring, shaming (industry codes

of conduct)

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Trends in Regulation

• Australia, NZ & United Kingdom‒ Public sector ownership to regulated private sector

‒ Prescriptive regulation to market based systems

‒ Some move back to prescriptive regulation in UK

• United States ‒ Regulated private sector monopolies

‒ Experimented with market based systems

‒ After a few failures some move back to prescriptive regulation

• Other countries‒ Experimenting with market based systems (some success)

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Instruments of Regulation

• Legislation‒ Statutes (inflexible)

• Subsidiary legislation‒ Regulations, codes, rules (less formal, interpretation

problems )

• Industry codes of practice‒ (enforceability problems)

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Why Have Regulation?

• Contain activity within prescribed bounds

• Marry private interest with public good

• Issues of:o Objectiveso Effectivenesso Efficiencyo Unintended consequenceso Incentiveso Motivation

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Efficiency

Effectiveness

Good regulation

Inefficient regulation(Resources are wasted, eg overly prescriptive regulation)

Ineffective regulation(Using price to regulate activity

where Pεd is low)

Bad regulation(WA’s Reservation Policy)

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Some Economics

Economic EfficiencyProductive efficiencyAllocative efficiencyDynamic efficiency (long run)

– Singularity– Inefficient trading arrangements waste resources– Does not address the distribution of income or

wealth

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Commodity 1

Commodity 2

Interests of Consumers

Optimum

Production Possibility Frontier

Technical Efficiency

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Objective Function

Maximise:• Long term interests of consumers

Subject to:• Meeting environmental objectives• Interests of investors & service providers• Re-elect Minister

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Commodity 1

Commodity 2

Election of Minister

Interests of Consumers

Interests of Investors

Continuous voting by consumers throughmarket

Allocative Efficiency

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Commodity 2

Optimum

Max π

Interests of Consumers

π= α

Dynamic Efficiency

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Physical Properties - Economics• Public vs Private goods• Excludability• Economies of scale• Economies of scope• Externalities (unintended consequences)

– economic, environmental, social & technical – complementary or substitution

• Barriers to entry – Infrastructure– legislative or regulatory– financial– access

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Supply of Goods & Services

Private GoodsBread, butter etc

Mixed GoodsPipelines, wires etc

Public GoodsFree to air, defence etc

Common Property GoodsFisheries, resources (oil, gas, water etc)

Rivalry

NotExcludable

Excludable

NoRivalry

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Normative Properties - Economics• Self interest

• Public interest

• Preferences

• Cultural traditions

• Beliefs

• Social standards

• Teachings

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No Proof of Hypothesis“The great difficulty in the social sciences (if we may presume to call them so) of applying scientific method, is that we have not yet established an agreed standard for the disproof of an hypothesis. Without the possibility of controlled experiment, we have to rely on the interpretation of evidence, and interpretation involves judgement; we can never get a knock-down answer. But because the subject is necessarily soaked in moral feelings, judgement is coloured by prejudice.”

(Joan Robinson, Economic Philosophy, 1962, p26)

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Prejudice

“Anyone who says to you:

‘Believe me, I have no prejudices,’ is either succeeding in deceiving himself or trying to deceive you.”

(Joan Robinson, Economic Philosophy, 1962, p26)

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Economics and Law

• Economics is not about being fair

• Economics is not about being equitable

• Economics is indifferent to individual circumstances

• In economics precedent does not count

Part 2

KPKSASEconomics and Law• Law is strong on procedural fairness

• There must be no perception of bias

• Equity plays an important role(Those in like circumstances treated equally, those in unlike circumstances treated differently)

• Precedent plays an important role• Mostly adversarial (inefficient & often ineffective)

• Errors of law problem (interpretation – prejudice)

• Review processes cumbersome & costly(It can take decades and big $’s to get it right)

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Issues in Regulation

• Project Discovery, Ofgem, United Kingdomhttp://www.ofgem.gov.uk/markets/whlmkts/discovery/Documents1/ERA%20response%20to%20Project%20Discovery%20-%20Options%20for%20delivering%20secure%20and%20sustainable%20energy%20supplies.pdf

• Inquiry into domestic gas prices, Western Australia http://www.parliament.wa.gov.au/web/newwebparl.nsf/iframewebpages/Committees+-+Inquiries

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Project Discovery, Ofgem, UK • Project discovery asks:

o are arrangements adequate in UK for delivering secure and sustainable gas and electricity over the next 10 to 15 years?

• Finding:o it concludes that significant action will be called

for given the unprecedented challenges facing the electricity and gas industries.

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Project Discovery, Ofgem, UK • Proposals:

o The project proposes measures ranging from:‒ improvements in pricing and/or obligations on suppliers

to deliver specific levels of supply security

to

‒ models that mandate or secure specific investments in new generating capacity and gas infrastructure

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Project Discovery, Ofgem, UK

• Issues:oObserves that the market is working well but concludes

that it needs changing – is this logical?o Proposes switching objectives away from efficiency, cost

effectiveness and timeliness to securing sustainable energy supplies at the lowest cost.

o Sustainability – a short term concept?oDon’t underestimate importance of adaptabilityo Project discovery introduces risk and uncertainty with

possible self fulfilling consequences.

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Project Discovery, Ofgem, UK • Issues:

oWhat are the unintended consequences of project discovery’s scenarios?

oWhat are the costs in switching objectives?o Is the availability of better returns in other areas of the

economy or in other countries a basis for market intervention? (sovereign risk?)

oAre issues concerning the functioning of the capital market relevant to the energy market?

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Project Discovery, Ofgem, UK • Issues:

oWho is responsible for ensuring energy security - government or the private sector?

oWhat is the risk and cost of centralised intervention proving to be unwarranted?

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Inquiry: Domestic Gas Prices WA • A legislative Assembly Committee (The

Economics and Industry Standing Committee) was directed to inquire into: omeasures that could be implemented to reduce the

price of natural gas in Western Australia

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The Problem • Gas for the domestic market in short supply

• Causes: o East Spar field watering ino Varanus Island disruptiono Domgas processing capacity limits (both NWSG & Varanus

Island)o Historical low contract gas prices led to concentration in

upstream market to two main domgas supplierso LNG producers short of feed stock (Wheatstone, Pluto)o Upstream cost escalation – the low hanging fruit has been

pickedo Tight and unconventional gas costly - WA lacks technology

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The Options • Regulatory or market fix, or both?

o Use it or lose it retention lease policyo Reservation policyo Separate gas marketingo Government imposed secondary gas market – is proposedo Centralised State gas aggregatoro State or national oil companyo Perth LNG import terminalo Government to fund tight and unconventional gas exploration

and developmento Broaden gas quality spec. – in progress

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Natural Gas in WA

NWS Gas(after moderate or minimum treatment)

Other fields

Extensive Treatment

Browse & Bonaparte Basin

Current DBNGP Spec.

Widening DBNGP Spec.

High cost CO2 or N2

removal

Committed for local contracts

Poss. NWSG contract ext.

Additional DBNGP

GGP

Pilbara

Committed for export

LNG Contract Extension

LNG Train 4

LNG Train 5

LNG Train 6 (Gorgon)

LNG Train 7 (Gorgon)

-

10,000

20,000

30,000

40,000

50,000

Reserves/Resources 1997

Gas Quality(excluding Browse & Bonaparte Basin)

Total Demand

PJ

(Current DBNGP Spec)

Total: 40 EJ

Total: 51 EJ

Total: 43 EJ

Source: Presentation to IIR Resources Outlook Conference “Gas Quality, Competition Policy and Economic Development in Western Australia”, K Peter Kolf, 1998.

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Domestic Gas Supplies1997 (TJ/d)

Carnarvon Basin

BHP Petroleum (Australia) Pty Ltd Griffin Gas Gathering 17

Boral Energy Resources Ltd Tubridgi 21

West Australian Petroleum Ltd Thevenard Island Gas Gathering 12 50

East Spar Joint Venture East Spar 40

Harriet Joint Venture Harriet Gas Gathering 79 119

North West Shelf Gas JV NWSG Project 428 428

Perth Basin

Boral Energy Resources Ltd Beharra Springs 29

CMS Gas Transmission of Aust. Dongara 11

Phoenix Energy Pty Ltd Woodada 4 44

Total 641

Source: Presentation to Centre for Mining and Energy, Sydney, “Upstream Regulation and Competition Reform”, K Peter Kolf, 14-15 October 1998.

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Quantity

The Price of Natural GasCost / Price ($/GJ)

Wellhead cost

Netback price

Domestic commodityprice

Alternate fuel price(Opportunity cost)

Negotiation - Pεd

KPKSASAll Ordinaries and S&P/ASX-200 Indexes

Source: Australian Securities Exchange web site, http://hfgapps.hubb.com/asxtools/Charts.aspx?asxCode=XAO&compare=comp_index&indicies=XJO&chartType=3&pma1=0&pma2=0&volumeInd=2&vma=0&TimeFrame=M10#

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Source: Department of Mines and Petroleum, WA Mineral and Petroleum Statistic Digest 2009, p13.Note that the Department lists its source as: Argus Monthly LNG (Prices include freight and regassing).

LNG Import Prices

KPKSASThe Price of Natural Gas

Source: Department of Mines and Petroleum,“Western Australian Mineral and Petroleum Statistic Digest 2009”, p13.Note that the Department lists its sources as: Argus Monthly LNG, EnergyQuest, and DMP.

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Source: Presentation to electricity market participants, “Short Run Marginal Cost”, K Peter Kolf, January 2010.

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Conclusions

• Objectives need to be clear• Regulation and the law, necessary, but need to be

minimised• Aspects of economics and law are in conflict (thus

inefficiencies)• Unclear where regulation is going (more or less

prescription?)• Liquid fuel and natural gas costs likely to continue to rise

(will put pressure on living standards)• Don’t underestimate the importance of adaptability