Proposals for physical constraint management Presentation to PEA James Mellsop Director Wellington 29 January 2013

1 Introduction  Two components of the framework for managing physical constraints –Nominations regime –Capacity allocation regime  Start by discussing nominations regime –A (necessary?) complement to capacity allocation regime  Then outline capacity allocation framework issues and four models

Nominations regime

3 Benefits and costs of a nominations regime Benefits of nominations regime on Vector system Costs of nominations regime on Vector system Provide information to anticipate capacity constraints and manage peaks (e.g., by interrupting) Transaction costs for shippers, but low given they already nominate on Maui. However, there are a lot more delivery points on Vector system – could the objectives be achieved by having individual nominations for the large gates, and a single aggregate nomination across all other gates? Assist in general pipeline managementOperational costs for Vector system TSO (e.g., pipeline model, changes to OATIS) Would facilitate adoption of use-it-or- lose-it rules Cost of instituting a daily allocation process for mass market customers, but such a process may not be essential Might facilitate secondary trading Would harmonise governance regimes across Maui and Vector pipelines, and might reduce transaction costs

4 Key requirements for nominations (1)  Important for all shippers to nominate –Even those with non-controllable customers and delayed gate allocation information –Need all shippers to nominate to provide information to anticipate capacity constraints –Peak demand driven by residential users (and generators)  Nominations only helpful if accurate –Need a (e.g., payment) mechanism to incentivise accuracy –Query whether tolerances should be higher for mass market retailers

5 Key requirements for nominations (2)  Needs to be link with Maui nominations –Including dealing with trades

6 Nature of shipper nominations  Shipper nominations and penalties for inaccurate nominations would be the only additions to the status quo –But penalty provisions may require changes to VTC –If the objective is to avoid VTC changes, then some capacity allocation models (models 1 & 4, discussed later) might be implementable without a nominations regime  Nominations would be independent of the capacity right and the CRF/TPF –Purely an information tool (on the Vector system)

Capacity allocation regime

8 Objectives  Efficient allocation of physical capacity when (anticipated) demand exceeds (anticipated) supply –Physical capacity allocated to highest value use  Price signal of the need for new investment/scarcity

9 Framework issues (1)  Want to ration capacity according to willingness-to- pay (WTP)  WTP could vary over time, so optimally determine at time of constraint (e.g., by an auction)  But auction at time of constraint may not be practical or cost effective –May not be enough time –May be disproportionate set-up costs if used rarely

10 Framework issues (2)  So instead define interruption rights and priorities in advance –Trades off allocative efficiency for practicality and cost effectiveness  But, subject to practicality, could update rights and priorities closer to real time –Improves efficiency as information improves –More up-to-date prices and investment signals

11 Pricing interruptibility  A firm contract uses the CRF as a fee for reserving capacity –Reflecting value/cost when capacity scarce  If there is less security in that capacity it makes sense to discount the firm CRF –Lower value/cost in times of scarcity  Interruptible contracts could therefore be sold with a discount to the firm CRF (but the same TPF)

12 Relationship between CRF and probability of interruption Firm capacity (not interruptible) “Limited” interruptible capacity (interruptible for, say, 5 days per winter) “Pure” interruptible capacity (interruptible at any time) Firm CRF Zero or low CRF Decreasing CRF Increasing probability of interruption Zero probability High probability

13 Costs and benefits to the TSO  For discussion: –Will the TSO incur material costs in introducing a nominations and/or capacity allocation regime? –What is the benefit of/incentive for the TSO to introduce these regimes? How does regulation affect the TSO’s incentives? Would the “reasonable and prudent operator” standard provide sufficient incentive? Would reputational risks for the TSO provide sufficient incentive? Would there be increased revenue uncertainty for the TSO?

14 Spectrum of change to existing governance arrangements Increasing change from existing governance arrangements Status quo Model 4: Status quo + contract/auction with end users for interruption Model 1: Status quo + contract/auction with shippers for firm-turned- interruptible contracts Model 2: Model 1 + contract/auction with shippers for interruption at primary allocation Model 3: Default non- interruptible right with price subject to change, with options to fix firm or interruptible capacity prices

15 Discussion of the models  All four models were discussed at the GIC workshop on 15 January  General view was that models 1 and 4 are worth pursuing in short-term –Also useful to consider a merged version of models 1 and 4  Will set out models 1 and 4 and merged version  For completeness, will also discuss models 2 and 3 –For longer-term consideration

16 Model 1: Option to buy interruptibility  Status quo, but at any time, TSO could run an auction to temporarily turn firm capacity into interruptible capacity (e.g., in autumn for the upcoming winter, or any other anticipated peak)  TSO might run this auction if concerned issued too much firm capacity –Enables TSO to be less conservative in primary allocation  Auction price could be reduced CRF –Reflecting lower capacity costs

17 Model 1: Example (1)  Suppose shippers 1 and 2 each have 1000GJ of A to B firm capacity –Suppose each pays CRF of $60/GJ per annum + TPF  TSO goes to market for 200GJ interruptible capacity  Each shipper offers to convert 200GJ of its 1000GJ to interruptible capacity –Shipper 1 offers to pay a CRF of $40/GJ on the 200GJ –Shipper 2 offers to pay a CRF of $25/GJ on the 200GJ

18 Model 1: Example (2)  TSO accepts bid of $40/GJ from shipper 1 for 200GJ –This being the smallest discount from firm CRF (of $60/GJ)  Shipper 1: –Pays $40/GJ + TPF on 200GJ interruptible capacity (but no TPF paid if shipper 1 is interrupted) –Pays $60/GJ + TPF on 800GJ firm capacity  Shipper 2: –Not interruptible, so pays $60/GJ + TPF on 1000GJ firm capacity

19 Model 1: Firm-turned-interruptible contracts (1)  Side contracts between TSO and shipper –Outside VTC?  Interruptible contracts would specify number of days of interruption (e.g., interruptible for up to five days per winter) with a specified trigger –Need mechanism to measure and ensure performance  Shippers need information to calculate probability of interruption –E.g., total pipeline capacity, capacity reservations, historical usage

20 Model 1: Firm-turned-interruptible contracts (2)  Actual interruption done on basis of pre-specified administrative rule –E.g., pro rata (by nomination, MDQ, historical usage, etc) – see next slide  But earlier self-selection should ensure a reasonable degree of allocative efficiency

21 Model 1: Administrative rule for actual interruption  Curtailment on Maui pro rata by net historical usage –But this is unlikely to be efficient  Another option is pro rata by nominated quantity –Balancing gas on Maui, and interruptible contracts on some Eastern Australian pipelines –Could be subject to gaming (although mitigated to some extent by incentive mechanism for accurate nominations)  Or pro rata by interruptible capacity –If AQ on Maui is curtailed it is pro rata by AQ holding –Here pro rata would be by interruptible capacity holding

22 Model 4 (1)  Top 10 or 20 major end users identified, whose interruption would be significant to the system  TSO would buy interruption from those end users willing to sell it  Perhaps less likely to achieve a price signal for scarcity –But could be formalised as an auction  Requires TSO to contract with end users, rather than shippers –What commercial and operational issues does this raise?

23 Model 4 (2)  Effectively lower CRF –TSO may make payments to end user  Might see demand aggregators contracting with TSO

24 Merged models 1 and 4  TSO could buy interruption from both shippers and end users  Allows TSO to contract with different parties in a way that minimizes transaction costs –May be simple for TSO to deal with large customers, but for smaller customers may be more efficient to go through shippers who already have contractual relationship Or other aggregators

25 Linking pricing to overruns (1)  Capacity constraints likely to involve overruns –So could overrun fees be passed on to interrupted shippers?  One rationale for overrun fees is to charge for an externality – other shippers/end users are crowded out –But externality charge is set administratively  Could (roughly/partially) compensate interrupted shippers/end users for crowding out by passing on overrun fee

26 Linking pricing to overruns (2)  Two approaches to achieve this –In event of constraint, allocate overrun fees to interrupted shippers/end users Expected transfer would be taken into account when bidding for CRF –In event of constraint, TSO retains overrun fees Lack of transfer would result in lower CRFs  No real difference (in economic terms) between the two approaches –Reduced CRF + expected transfers = expected loss

27 Linking pricing to overruns (3)  Not necessarily straightforward to anticipate overrun transfer –Quite variable –May not even be any overrun fees?

28 Linking pricing to overruns: example (1)  Recall shipper 2 (from previous example) has 1000GJ of firm capacity –Suppose shipper 2 overruns and uses 1200GJ on a day –Pays an overrun charge of approx $1.32/GJ per day (8 x CRF of $60 ÷ 365 days) –A single overrun of 200GJ on a day would incur a charge of approx $260 ($1.32/GJ x 200GJ)  If, because of the overrun, shipper 1’s 200GJ is interrupted, the $260 overrun charge might be passed to shipper 1

29 Linking pricing to overruns: example (2)  Shipper 1 would incorporate the (expected) transfer of $260 into its bid prices –It could bid a higher CRF (than the original $40 bid) on its interruptible load, because the overrun charge transfer compensates for the higher CRF it pays  Alternatively TSO might retain the overrun charges –Shipper 1’s bid would remain at its original $40 bid

30 Model 2 - overview  Same as model 1, but adopts some of PEA’s July 2012 recommendations, e.g., –Interruptible contracts available at primary allocation –Auction mechanism in primary market  Would likely require more changes to the existing governance arrangements than model 1 –To both VTC and MPOC

31 Model 2 (on Vector pipeline): Primary allocation (1)  Shippers self-select between two types of standard form contract –Firm; or –Interruptible (e.g., interrupted for a specified number of days, with a specified trigger)  Both contracts would be single year, but with grandfathering rights (amended as per PEA’s July 2012 paper)

32 Model 2 (on Vector pipeline): Primary allocation (2)  If supply exceeds demand for either contract –CRF administratively set to recover sunk costs –CRF for interruptible lower than firm –TPF set at variable cost, same for firm and interruptible  If demand exceeds supply, contracts auctioned –Bidding would set upfront price CRF would remain administratively set Note different approach to firm-turned-interruptible –Need a mechanism for dealing with scarcity rents

33 Model 2 (on Vector pipeline): Buying (more) interruptibility  As with model 1, interruptibility is purchased as required, i.e., temporary firm-turned-interruptible contracts

34 Model 2 (on Vector pipeline): Rationing capacity  Actual interruption done on basis of pre-specified administrative rule –E.g., pro rata (by nomination, MDQ, historical usage, etc)  But earlier self-selection should ensure a reasonable degree of allocative efficiency

35 Model 2 (on Maui pipeline)  Shippers self-select between two types of standard form access right: –Common carriage, which is interruptible; and –AQ (which might need more careful definition)  AQ not currently used, but would expect demand for it to rise as pipeline becomes fuller  Once these rights are defined, model 2 on the Vector pipeline applies –Including TSO buying (more) interruptibility (if necessary)

36 Concluding thoughts on model 2  Would move two regimes closer to one another –More “common carriage” elements added to Vector regime –More “contract carriage” elements added to Maui regime  Model 2 is relatively easy to implement –Main requirement is for interruptible contracts to be put in place –At least some elements could possibly be done outside the VTC?

37 Model 3: Primary allocation  Default property right similar to common carriage – no contract for capacity –But, unlike common carriage, it would be non-interruptible –Tariff would be subject to periodic change, and could include a peak fee –Likely to be most suitable for non-controllable load  But if price certainty required, shipper could reserve capacity for a fixed term and fixed (higher) price  Shipper could also reserve interruptible capacity for fixed (lower) price

38 Model 3: Buying (more) interruptibility and rationing  As in models 1 and 2, TSO could contract to convert firm into interruptible capacity  Rationing of capacity also same as model 1 and 2, based on pre-specified administrative rule  Model 3 would be the greatest departure from the governance arrangements of the status quo

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