THE PEA ON GAS TRANSMISSION ACCESS AND PRICING: APRIL 2013 Drafted by Graham Scott and Lewis Evans

AGENDA 1. Revised terms of reference 2. State of the market 3. Context 4. PEA thinking 5. In Progress 6. Workshop Topics

1.REVISED TERMS OF REFERENCE

PEA: Ideal (natural monopoly) gas transmission market characteristics Overarching goal of dynamic efficiency: i.e. maximise efficiency at points in time subject to enabling investment at times that enhance efficiency in the present and the future 1. Minimum costs (including transaction costs) of governing and operating efficient transport arrangements 2. Maximum efficient use of physical capacity, particularly at times of capacity scarcity 3. Competition in related markets not distorted 4. Efficient investment in related markets facilitated 5. Investment in pipelines facilitated 6. Independence of functions in governance and operation 7. Appropriate operational and commercial transparency 8. Arrangements to evolve in a timely fashion (meet changing needs) Thursday, April 11, 2013 Panel of Expert Advisers 4

PEA: governance for access regimes that evolve efficiently with the size of the market There are different sorts of access arrangements Each is best adapted for a particular environment, and Some are substitutes for each other PEA seeks governance and processes that promote dynamic efficiency for NZ… So PEA must consider longer term issues that affect the VTC and MPOC as well as any changes feasible/useful in the short term Two Background Issues When a pipeline becomes fully (physically) congested; real social (including competitive) benefits come from economic expansion of the pipeline vs tinkering with access arrangements The PEA is not charged with considering investment decisionmaking processes: but the access regimes should facilitate investment decisions Thursday, April 11, 2013 Panel of Expert Advisers 5

2.STATE OF THE MARKET 6

Few Large Users: (source Concept Consulting: North Pipeline TJ/yr) Contracts various: include fixed term and tradable About 43% capacity grandfathered Panel of Expert Advisers 7 Thursday, April 11, 2013

Daily Throughput ( source Concept Consulting) Volatility: across years/seasons/weeks Panel of Expert Advisers 8 Thursday, April 11, 2013

Growth in demand: negligible ( source Concept Consulting) Average annual growth rate: Thursday, April 11, 2013 Panel of Expert Advisers 9

Peakiness has increased: (source Vector Modelling Pres. 11/2011 ) Greater Auckland Flow Rate 5-day Peak)

Complex to define physical capacity: security of supply must be assured profile example: (Vector Gas Transmission: Rotowaro-North Pipeline Capacity Determination: Dec 2012) Physical capacity Physical capacity – allowance for survival time: e.g. at pressure drops Peak Week (contract) Profile b Winter Adjustment: a Unused operational capacity a-b or 8.8 to 23.6 TJ/Day Thursday, April 11, 2013 Panel of Expert Advisers 11

Vector Pipeline Management Activity Vector consulted on how it assesses the capacity of its pipelines o Explaining modelling assumptions and inputs o Disclosing decision making; Vector has substantially raised awareness of: o Vector’s security of supply standard o The Reasonable and Prudent Operator (RPO) standard Provided a bulletin board for secondary trading Panel of Expert Advisers 12 Thursday, April 11, 2013

Vector Pipeline: 2 important developments Transmission contracts to Otahuhu and Southdown renegotiated o Aggregate firm capacity reduced o Additional capacity is now interruptible o Additional (supplementary) capacity is now tradeable Better understanding of physical and commercial capacity: need to interpret carefully, but Considerable available commercial capacity on most sections; although North System: significant capacity available except Greater Auckland where only 11% (6972 GJ/Day) is uncommitted, Otahuhu B/Southdown where 10%(10,348 GJ/Day) is uncommitted and Kauri/Maugaturoto where 8% ( 420GJ/Day) is uncommitted. Panel of Expert Advisers 13 Thursday, April 11, 2013

Present State of the Market: summary Panel of Expert Advisers 14 A: Generally excess capacity on transmission: though throughput getting peakier Presently Maui similar capacity position to Vector, but Cost of Maui expansion less than Vector capacity expansion; particularly North of Auckland B: Much uncertainty about demand growth relative to capacity because of demand uncertainty active gas field uncertainty, and electricity transmission investments. C: Available large users economically assist the management of congestion D: Potential for the situation to stay in the same position for the foreseeable future, but if demand does grow congestion would arise quickly Thursday, April 11, 2013

3.STATE AND EVOLUTION OF PIPELINE MANAGEMENT PROCESSES Panel of Expert Advisers 15

Approach: Panel of Expert Advisers 16 Dynamic efficiency implies there should be transparency: on actual and potential pipeline use preparedness in governance; so efficient processes can be applied in a timely way to the (potential) evolution of pipeline utilisation. Thursday, April 11, 2013 Many seemingly different systems and options are not that different: illustrate by MPOC/VTC

State of Systems Maui and Vector Pipelines Governance/Operation Panel of Expert Advisers 17 MauiVector Multilateral contract with pipe owner MPOCVTC Technical & System Operation Vector TSOwnerMDLVector Vertical IntegrationYes Transparent in aggregate (short term) daily delivery YesLess relevant Entry availabilityAny capacityContracts available Transparent shipper pipeline activity no Daily availability no

State of Systems Maui and Vector Pipeline Management Panel of Expert Advisers 18 MauiVector Nominations (short term)YesYes: interruptible contracts Penalty: nomination violation Yes Shipper security without congestion Run to desired nomination Run to contractual maximum Curtailment (Security with congestion) On historical use (up to 70% capacity could be AQ: none at present) On interruptible contract Scarcity PricingNoSome (unclear related to interruptible pricing) Market Scarcity PricingNoNo: tradability gives potential Thursday, April 11, 2013

State of Systems Maui and Vector Pipelines: various Panel of Expert Advisers 19 MauiVector Gas balancing marketyesno Critical ContingencyCommon process Point to pointyes State of use relative to capacity Presently uncongested, congestion with demand growth same Commerce Commission price /revenue regulation yes Thursday, April 11, 2013

System Evolution I Systems and Physical Capacity Pipe Utilisation point-to-point Gas Spot Market Separate from Transmission VIC/NSW Carriage Maui & Vector contract Point-to-point Shipping Maui & Vector contract with interruptible Nodal entry/exit transactions Input need not equal take System cost (&Functional Specialisation) Point-to-pointAs above + market pricing nominations Thursday, April 11, 2013 Panel of Expert Advisers 20

System Evolution II Systems and Physical Capacity 21 Pipe Utilisation Gas Spot Market Separate from Transmission Carriage Maui & Vector Shipping Certainty Maui & AQ Vector contract with interruptable Shipping Price volatility High As above + market pricing nominations Variable Thursday, April 11, 2013 Panel of Expert Advisers

System Context: the details matter Maui and Vector are not that different I 22 Maui has open access but any shortfall is absorbed by recent entrants Maui has no contractual certainty but Could put it in place with its AQs Some certainty exists for existing shippers (s.t. allocation according to last 12 month - so in effect ‘use it or lose it’ with lag) Vector has contractual access when capacity is available (as now) Vector provides contractual certainty and can utilise physical capacity well with interruptible load, (and tradability) Vector utiliisation is somewhat less transparent: in part because of the implications for transparency its contractual basis of operations Thursday, April 11, 2013 Panel of Expert Advisers

System Context: Maui and Vector are not that different II 23 Vulnerability for entrant shippers increases with demand growth in both systems Maui has open entry but ex post historical-use curtailment Vector ex ante availability of firm and interruptible contracts In both shipping does not follow load without affecting quality/security (contract tradability some exception) of shipping when there is congestion Same critical contingency process The governing processes of the systems could reasonably converge Thursday, April 11, 2013 Panel of Expert Advisers

System Context: Maui and Vector Common Governance issues 24 Both have Part IV of the Commerce Act price/path regulation As capacity becomes scarce: pricing capacity generates scarcity rents that may well be volatile Regulators may allow these to be retained by the network owner but their volatility creates practical difficulties in offsetting them elsewhere Need rent distribution that does not distort capacity pricing Might prepare for scarcity pricing and rent retention by an entity separate from the pipelines (in some jurisdictions this is a regulator) Vertical integration of TSO may limit TSO’s trading credibility Thursday, April 11, 2013 Panel of Expert Advisers

System Context: Maui and Vector common issue 25 Investment in transparency (e.g. IT systems) Whether or not be recoverable by the pipeline owners under regulation; Might devolve cost and management to the industry regulator; or an independent market-maker: wider industry benefits than pipeline owners and industry should pay; Thursday, April 11, 2013 Panel of Expert Advisers

4.PEA THINKING Panel of Expert Advisers 26

PEA Thinking: Vector and Maui 27 The Vector and Maui systems Span blends of available options: contract and common carriage Are multilateral contracts suited for the current position of excess capacity, future growth in throughput of each is very uncertain; Current Maui and Vector MPOC and VTC (with interruptible contracts) are reasonable management systems for the present state of throughput but not for throughput that requires congestion management Establishing governance that is efficient and enables timely changes in process is desirable. (Starting points for change are MPOC and VTC multilateral contracts) Critical contingency arrangements are reasonable for the foreseeable future Thursday, April 11, 2013 Panel of Expert Advisers

PEA Thinking: Vector and Maui I 28 In any future arrangement there should be provision for long term security of access in at least a proportion of the pipeline: particularly for green-fields investment on and off pipe. Any solution to security of access must match with a solution to congestion management Both Maui and Vector give similar security to ongoing users; Maui’s has the use it or lose it feature (after a 12 months), grandfathering does not: but both have “in perpetuity” features: Grandfathering contracts be limited. The combination of open access provisions for a significant fraction of pipeline capacity and firm shipping (e.g. modified AQ to make it firmer in MPOC and interruptibility in VTC) for the remaining fraction, particularly for greenfield investments provides a promising evolutionary roadmap Thursday, April 11, 2013 Panel of Expert Advisers

PEA Thinking: Vector and Maui II 29 Conceptually the key difference between 1.VTC with nominations for interruptible load and 2.MPOC with AQs established as firm contracts is that congestion is planned to be managed at entry by VTC and post entry by MPOC. If historical-use and contractual grandfathering were eliminated with near-term nomination pricing there would be no significant difference. The combination of open access provisions for a significant fraction of pipeline capacity and firm shipping (e.g. modified AQ to make it firmer in MPOC and interruptibility in VTC) for the remaining fraction, particularly for greenfield investments provides a promising evolutionary roadmap Thursday, April 11, 2013 Panel of Expert Advisers

PEA Thinking: transparency I 30 Transparency is needed in both Maui and Vector systems to enable observers and participants – including ministers, ministries, regulators, end users, potential shippers and actual shippers – to make informed decisions quickly and easily It is required at current and higher throughput levels Both Maui and Vecrtor systems should reveal in a very user friendly way the state of capacity, and its utilisation; the nature of contracts available and in-place, including their price; and the information should be made public unless there is a good reason to the contrary Thursday, April 11, 2013 Panel of Expert Advisers

PEA Thinking: transparency II 31 Note that Vector system may be less transparent than Maui reflecting in part the different regimes – but under the roadmap there would be some convergence in transparency If such transparency is limited by the VTC or MPOC these codes should be changed Transparency may require investment in (e.g. IT) systems. Such costs may be recoverable in principle under the Part 4 regulation but there are timing and practical issues. Consideration should be given to contracting the transparency task to the industry regulatory body or to a party contracted to provide this service Thursday, April 11, 2013 Panel of Expert Advisers

PEA Thinking: congestion management 32 Efficient management of access and congestion in the presence of congestion requires allocation on the basis of prices (willingness to pay) allowing for the terms of contracts for access Arguably the long term future could be best served by relaxing current point to point pricing and providing a gas spot market price at each node. Such a system is likely justifiable only when physical capacity is continuously and significantly constrained and the gas industry has expanded. Regardless of the best path that is chosen for the development of the market for gas, the next steps in the development of pricing and allocation of physical capacity in the pipelines are our immediate focus. Short term, nominations on a point to point (zone) basis are needed to enable the pipeline operator to assess the utilization of capacity as the basis for triggering if necessary the method of managing scarcity Thursday, April 11, 2013 Panel of Expert Advisers

PEA Thinking: congestion management I 33 Suggest consider some form of the intermediate step where nominations are present; and Priced for allocation Nominations in the Vector system will require some expenditure. Evaluation of it in the context of the MPOC and VTC system would be appropriate. Thursday, April 11, 2013 Panel of Expert Advisers

PEA Thinking: Maui and Vector 34 there is much similarity between these pipelines It is quite possible that they would approach congestion with increased throughput at similar times Efficient governance and rules is an integrated system with elements of MPOC and VTC It is likely that efficient management is an ISO operating a combined system Thursday, April 11, 2013 Panel of Expert Advisers

5.PEA: IN PROGRESS Panel of Expert Advisers 35

PEA In Progress Consider the effect on incentives on Vector (and MDL) and TSOs to manage for timely change in the presence of Part IV regulation More precision on form and pricing of nominations Panel of Expert Advisers 36 Thursday, April 11, 2013