Note No. 179 April 1999 Regulation in New Natural Gas Markets— The Northern Ireland Experience Peter Lehmann 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.1 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 had 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 ronmental reasons and to make the province may develop. Indeed, in a new gas industry it more 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 Northern Ireland, with com- region or country. In that case it may be best to missioning in 1996. The plant was owned by develop the network as a series of regional fran- British Gas (now BG), and the gas is transported chises. That way, two or more licensees will 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 industry. Monopoly in transportation To take up this opportunity, a license for natural 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) transportation one other candidate. Phoenix was originally a 100 monopoly period was needed to attract an percent subsidiary of BG, though Keyspan Energy investor into the market. The necessary invest- now has a 24.5 percent shareholding. Phoenix ments appeared to British Gas/Phoenix to be was granted a combined license for transport and fairly marginal. Major marketing risks stemmed supply, but different approaches were used for from having to displace coal, liquefied petroleum the two activities. An exclusive transport license gas, and oil in the residential market and from the lasts twenty years, but competition in supply will 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 600,000 households, 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 h e Wo r l d B a n k G r o u p ▪ F i n an c e, P r i v at e Sec t o r, an d In fr as t r u c t u r e N e t wor k Regulation in New Natural Gas Markets—The Northern Ireland Experience financial risks. The authorities 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 infrastructure licenses were granted. fails. Thus other companies could then be granted transportation licenses. The authorities also agreed with British Gas/ Phoenix that a single license would have other Transportation charges advantages. A single developer is more likely to develop an optimal, well-designed “backbone” From the outset Phoenix has maintained separate network (avoiding, for example, multiple pipes charges for the use of the transport network by 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 introduced, the of granting approvals, planning traffic, making transport charge will simply be a transfer price contingency plans, and providing local authority between Phoenix’s distribution and supply support services. businesses. Development obligations Both Phoenix and the authorities recognized that the price to final customers would have to be One of the authorities’ primary goals was to kept low for many years to persuade customers secure the construction of an extensive natural to switch to gas and that the overall costs of sup- gas pipeline system in Belfast. Thus investment plying gas would be dominated by the transport obligations were a key part of the license. Several charges. Thus the debate over pricing focused 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 with unforeseen circumstances. charges are not appropriate for a new industry. The regulatory asset base starts from zero, The license requires Phoenix to complete its net- changes rapidly, and is unpredictable. If charges work in twelve years and to perform the work in are based on a return on assets, they would be each of Belfast’s twelve districts in a specific order, exceptionally high at the outset (because of low within a specified timeframe. Moreover, a pipeline utilization) and would change sharply from year must run within 50 meters of 90 percent of the to year. Thus it was decided to set transport homes in each district. This was a much more charges at a level that is expected to provide an detailed blueprint than Phoenix would have liked. 8.5 percent real pretax return on cash flows over Phoenix argued that it already had major sunk twenty years, with calculations based on fore- investments—in medium- and high-pressure cast capital and operating costs, sales levels, and pipelines—and so had the necessary commercial mix of sales. Phoenix considered 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 safeguards for prospect of additional transport revenue after Phoenix reduce but do not eliminate the risk: the initial twenty-year license period. The big ▪ The regulator can agree to changes in the question 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 ▪ Phoenix 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. had not converted to, and does not intend to Under these reforecasts the previous five years convert to, natural gas. will be “water under the bridge”—that is, Phoenix will retain any gains and bear any The scope for competition may be limited given losses if developments differ from what was the small or nonexistent margins between 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 would 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 when 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 with 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 wanted 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 with 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 industry’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 two 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 ests 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 two 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 also been a short- 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 ground rules will change rapidly—both sides need to recognize It is still early days, but so far it has been the mar- this. The lack of an asset base and the absence ket rather than regulation that has had the major of “entrenched” high operating costs will also impact on the development of the Northern affect the regulator’s approach. In any case the Ireland gas industry. normal regulatory battle—where the regulator wants low prices and the company wants high This Note has been prepared with the help of Gearoid Lane, Chris profits—will likely be replaced in the early years Murray, and Martin Plackett of Centrica, United Kingdom. 1 The European gas directive, which provides separately for emerg- by a major shared objective: both sides want ing markets, recognizes this. rapid penetration of the market. Furthermore, at the initial stages the fledgling industry will be a small or medium-size company and should not Peter Lehmann (all@lehmann.demon.co.uk), be burdened by unnecessarily high costs of until 1998, Commercial Director, Centrica, funding the regulator’s office, staffing a big reg- now Chairman, Energy Saving Trust, United ulatory affairs team, and funding inquiries from Kingdom the Monopolies and Mergers Commission. Viewpoint is an open Conclusion forum intended to encourage dissemination of and debate on ideas, A lack of good precedents and credible compet- innovations, and best ing offers made negotiations over the gas license practices for expanding unusually difficult in Northern Ireland. For good the private sector. The views published are reasons, the approach taken to choosing the those of the authors and licensee was partly but not fully competitive. In should not be attributed some circumstances a more competitive process to the World Bank or any of its affiliated organiza- might be better. Still, the license that emerged tions. Nor do any of the may be useful for anyone working on the regu- conclusions represent lation of new gas industries. official policy of the World Bank or of its Executive Directors or In the two years since license discussions were the countries they concluded, Phoenix has completed the initial represent. development of its network, meeting all regula- To order additional tory targets and overcoming some inevitable dif- copies please call ficulties. Moreover, Phoenix’s gas prices have 202 458 1111 or contact Suzanne Smith, editor, been lower than was anticipated. Room F11K-208, The World Bank, Still, the market has posed some tough challenges. 1818 H Street, NW, Washington, D.C. 20433, Competing fuel prices have been low (especially or Internet address for oil), and threatened competitors, especially in ssmith7@worldbank.org. residential markets, have fought back. The North- The series is also available on-line ern Ireland Housing Executive, which had needed (www.worldbank.org/ to demonstrate impartiality between fuel suppli- html/fpd/notes/). ers, has only recently announced that natural gas Printed on recycled is the preferred fuel. As a result fewer of the exec- paper. utive’s properties have been refurbished with gas