PHD House, New Delhi September 24, 2009 Presentation to Petrofed Members Policy & Regulations on Natural Gas Pipelines & way forward…

Presentation covers…  drivers for gas markets & models  gas market development stages  Indian gas market  downstream regulatory framework  way forward…

drivers for gas markets & models

context… drivers for gas markets  discovery of substantial quantities of gas in association with oil drilling (USA) or large discoveries of non-associated gas in industrial nations (Europe)  strong desire to reduce urban pollution caused by coal or heavy fuel oil (UK, Germany) supported by GDP levels & personal affluence to make gas a fuel of choice  strong support from government (all countries)  comparative shorter transport distances boosted development of pipelines (Netherlands & UK)  existing coal based “town gas” grids facilitated market penetration (UK, USA & Germany)  gas was priced competitively against existing fuels (Germany & Netherlands)  use of more polluting fuels was discouraged (UK & Netherlands)  countries that are substantial net importers of energy wish to diversify primary energy supply (Korea & Japan post 1970’s Gulf oil crisis) three principal models of market development…

gas industry development model 1 private monopolies (multiple networks) regulationderegulation open access “private Monopoly” (or oligopoly) model is typical of USA (FERC) & to some extent Germany (Self regulated basis)  local town gas grids are connected by multiple, privately owned gas networks  gas transportation typically takes place on a monopoly or occasionally “contract carriage” basis  regulation of market becomes a necessity to promote orderly development, private investment, long term consumer gain & to encourage responsible operators  long-run regulation tends to create distortions & inefficiencies, leading to deregulation & development of open access regimes, typically on a “contract carriage” basis isolated grids

gas industry development model 2 development of State-owned monopolies has occurred in a number of countries, notably UK & France nationalisation state monopolies (single networks) privatisation open access liberalisation isolated grids  local town gas grids declined, following development of electric lighting, were later nationalised & consolidated by post-war governments  introduction of natural gas in 60s’ & 70s’ sees state funded development of transmission networks & conversion programmes  privatisation of state assets seen in UK & South America (now under consideration in France) …typically after up to 30 years of state ownership  UK model has evolved to fully open access…partial access in France

hybrid monopolies (mixed private/ state) open access public/ private development liberalisation separation gas industry development model 3 isolated grids In a number of countries a partnership between State & private industry has driven developments…as seen in Netherlands  development of industry viewed by government as a national priority  government takes an equity stake along gas chain or is heavily engaged as facilitator or guarantor  no privatisation…government retains stake in assets prior to adoption of an open access system typically 30 – 40 years later

gas market development stages

classification of gas industries gas industry of any country can generally be defined on two axes of infrastructural or market sophistication BasicEmerging Emerging/ Restructuring Sub-MatureMature Sub-Mature/ Restructuring 1 – 2 gas sources. Some high pressure transmission pipelines with <10 off take points to power generation or primary/ secondary industry 2+ gas sources. High pressure transmission with <100 off- take points for power generation and industrial usage. Some LDCs in major cities but with limited penetration into domestic energy sector …so for emerging but requiring significant refurbishment & modernisation. Significant capital injection required 4+ gas sources. Nationally extensive transmission system with significant industrial& commercial market share. Growing need for integrated grid control with seasonal load balancing needs beyond use of line pack. Distribution networks in all major towns with significant domestic market penetration …so for sub- mature but requiring significant refurbishment & modernisation. Significant capital injections required multiple gas sources, flexible & integrated gas grid. Approaching saturation in geographical coverage to “economic” customers. Ongoing maintenance & capacity expansion programmes Infrastructural Maturity

same applies to market sophistication state monopolyprivate monopoly emerging (competitive) emerging (restructuring) liberalised state owned transmission assets, municipal ownership of local distribution grids. Strong horizontal & where appropriate, vertical integration. De facto regulation by government ministries significant private ownership of transmission & distribution assets. National monopoly or regionally focused oligopoly in transmission, distribution & supply. Limited negotiated TPA to transmission networks. Regulation by statute &/ or state ministry governmental or supra- governmental drive for competition & break-up of monopolies. Negotiated access to capacity, rudimentary energy balancing/ settlement mechanism. Government appointed independent regulator and/ or supra-national body so for “Emerging Competitive” but including partial (accounting) or legal separation transportation & shipping. Developing non- discriminatory access to capacity, cost reflective energy balancing & settlement mechanism. Independent regulatory body focused on promoting competition & limiting monopoly powers ranging from partial (Industrial & commercial) to full (including residential sector) liberalisation. Full separation between transportation & supply. Horizontal integration with dual fuel suppliers. Fully non-discriminatory access code with mature energy balancing & settlement regime. Regulatory emphasis shifts from competition towards incentivising network efficiency classification of gas industries

plotting relationships - markets & regulation no two gas markets are exactly alike, but high level classification is possible along two axes – parabolic relationships state monopoly private monopoly emerging competitive liberalised basic emerging sub-mature mature market/ infrastructure ownership/ regulation (restructuring) infrastructure & market maturity structure

different stages of development none state monopoly private monopoly emerging competitive liberalised none basic emerging sub-mature mature market/ infrastructure ownership/ regulation (restructuring) Chile Venezuela Turkey Singapore Egypt Brazil India China Taiwan Saudi Arabia Philippines Bangladesh USA UK Spain Norway Netherlands New Zealand Korea Italy Germany Belgium Australia Argentina Ukraine Japan Russia France relative position of gas markets

gas market development case studies

UK State Monopoly Private Monopoly Emerging Competitive Liberalised Basic Emerging Sub-Mature Mature Nationalisation of private gas companies Full unbundling of transportation & supply Full I&C and residential competition Privatisation and limited TPA evolution of UK gas market UK is now an advanced liberalised gas market… but how did it get there?  extensive town gas system dating back to 1860s’  nationalised in 1948  small natural gas network created early 1960s for Algerian LNG  gas discovered in North Sea 1965  national transmission system constructed 1967 – 1973… town gas systems converted  British Gas privatised  full I&C competition  full residential competition  now bedevilled by regulatory complexity

EU gas market is not what it used to be… recent past  emergent markets  exclusive rights (infrastructure & supply)  national monopolies  demarcation zones  no gas-to-gas competition  gas prices contractually linked to oil  vertically integrated companies near future  mature but growing markets  equality of market rights  freedom to invest and sell  several players in all markets  integrated market with TPA  gas-to-gas competition  gas prices also a function of gas- to-gas competition (market- based)  legal separation of transportation ….transition towards a new world with new roles, business models & risks

European gas market maturity during past 30 years, Europe has matured into a large, integrated gas market maturity of infrastructure allows progress towards more liberalised market models

evolution of US gas market State Monopoly Private Monopoly Emerging Competitive Liberalised Basic Emerging Sub-Mature Mature USA different development path in USA - huge geographical scale with strong free market ethics  parallel evolution of natural gas & town gas since early 20th century  rapid expansion post 1945 via competition between private monopolies  strict regulation of prices & development introduced to curb excess & manage development  deregulation of interstate pipelines under FERC 501 in 1986 with progressive deregulation of pipelines  different states moving towards fully liberalised markets at varying speeds  regulatory model adapting to meet security of supply issues

gas pipelines in USA (Lower 48) USA enjoys a substantially mature gas pipeline network, linking demand centres with traditional sources of supply FERC regulates interstate pipelines & SERCs’ regulate intrastate pipelines

evolution of Dutch gas market Dutch market model follows lines of a unique private industry/ state collaboration State Monopoly Private Monopoly Emerging Competitive Liberalised Basic Emerging Sub-Mature Mature Netherlands Gasunie unbundled in 2004  small legacy town gas industry  super-giant gas discovery at Groningen in 1959  state/ private entities of Gasunie, NAM and Maatschaap created in 1963  main pipeline construction phase (internal & export)  rapid penetration achieved by competitive pricing against other fuels  implementation of EU competition directives saw unbundling of Gasunie

evolution of German gas market Germany State Monopoly Private Monopoly Emerging Competitive Liberalised Basic Emerging Sub-Mature Mature ? German gas market is unusual in Europe, having no direct State involvement, but self regulation  conventional town gas origins, first imports of natural gas in early 1960s  Germany has always been heavily dependent upon imports  no direct State participation but heavy involvement as facilitator & guarantor  multiple transporters, distributors & LDCs…main period of infrastructure growth 1975 – 1995, undergoing consolidation  ongoing liberalisation under EU directive though with a weak regulatory model (energy regulation has been made a sub- department of the telecom regulator)

State Monopoly Private Monopoly Emerging Competitive Liberalised Basic Emerging Sub-Mature Mature Korea evolution of South Korean gas market Partial privatisation split of KOGAS in 2003 Korean gas market is entirely LNG based around State owned transportation infrastructure & private LDCs  KOGAS formed in 1983 to develop industry…first LNG imports in 1987  varied State, private & municipal ownership  3 LNG import terminals, 20 separate LDCs’  strong government involvement in providing subsidy & fiscal relief for infrastructure development, in building regulations & for bus conversion  driven by need for supply diversity & environmental improvements  planned privatisation & separation of KOGAS into 3 separate supply companies in 2003 but considerable difficulties exist due to political & union resistance

generic gas industry development Path Ownership / Regulation State Monopoly Private Monopoly Emerging Competitive Liberalised Basic Emerging Sub-Mature Mature Market / Infrastructure at a high level, similar patterns emerge around the world  there is no example of a substantial gas market emerging from a fully liberalised market  theoretical economic attraction is not borne out by evidence

Indian gas market

natural gas demand: latest outlook Latest outlook as per 11 th plan document (MMSCMD) Sector Power Fertilizer5279 City gas Industrial Petrochemicals/ refineries/ others/ internal consumption Sponge iron/ steel778 Total

Indian gas industry  Power & fertilizer prime consumers (70%)  Captive & industrial consumption (30%) POWER FERTILISER PETROCHEM/ LPG STEEL INDUSTRIES CITY GAS/ CNG

projected imports of natural gas © OECD/IEA

LNG sources: India

LNG Existing (12.5 MMTPA) Transmission Pipelines Existing JAGDISHPUR PHOOLPUR BHATINDA JAMNAGAR BAREILLY DISPUR DELHI AGARTALA BARODA SURAT KANPUR LUCKNOW PATNA AHMEDABAD RAJKOT KOTA MATHANIA GWALIOR VIJAIPUR INDORE UJJAIN AGRA KOLKATA GAYA BOKARO VARANASI JHANSI Iran-Pak-India Pipeline Turk-Afg-Pak-India Pipeline DAHEJ I & II 10 mmtpa* HAZIRA 2.5 mmtpa DABHOL 5 mmtpa COCHIN 5 mmtpa MYANMAR-India Pipeline A 1 BLOCK, MYANMAR Upcoming (10.MMTPA ) Planned (8,400 Kms) City Gas/ CNG Existing (10 cities) Planned approx(28 cities) Gas By Sea Receipt) LNG Terminal COIMBTORE MANGLORE MUMBAI BHUBANESHWAR KRISHNAPATNAM NELLORE CHENNAI TUTICORIN TIRUCHCHIRAPALLI PUNE BHARUCH DABHOL HASAN BANGLORE KOLHAPUR HYDERABAD SOLAPUR RAJAMUNDRY VIJAYAWADA DAMRA KOCHI KANJIRKKOD AURAIYA gas sector infrastructure: current & future Ennore (proposed) 5 mmtpa emerging signs of maturing domestic gas market: plans afoot to have basic gas grid connecting sources of domestic gas, LNG terminals & demand centers

downstream regulatory framework… natural gas pipelines

 seek orderly sectoral growth & entry control promote efficiency productive: competition & reasonable cost allocative: who remains in market ? signaling role of price: cost reflective pricing  equity fair play: access to natural monopoly assets managed transition: legacy of controlled market (with state ownership) to robust segmented market compliance – all stakeholders to adhere to rules & regulations, minimum service obligations & civic norms regulatory design: objectives…

govt. policy on gas pipelines…  upfront provisioning of tax incentive u/s 80-IA (4) for infrastructure benefits: however, IT Act provides for 25% extra capacity, which is at variance with that in GOI policy for pipelines (33% extra capacity)  interchangeable use of common carrier or contract carrier in policy document & PNGRB Act, yet internationally gas markets have first been contract carriage systems before graduating into mature common carriage or hybrid systems  time frame for unbundling, which is key to creation of independent “shipping interest” not firmed-up

 covers pipelines including spur line for transport of natural gas along with connected equipments & facilities, but excludes dedicated pipelines for transporting natural gas to specific customer to meet specific requirements (& no re-sale) pipelines in a CGD network  EOI followed by bidding route (or Suo Motu by Board)  does provide enabling platform with minimum technical qualification requirements net worth & bid bond linkage with pipeline length ensures serious bidding authorization process…

 PNGRB may modify or accept EOI depending upon gas availability or need to expand an existing pipeline & guided by objective (s) of: promoting competition among entities; avoiding infructuous investment; maintaining or increasing supplies or for securing equitable distribution; ensure adequate availability of natural gas throughout the country; protection of customers’ interest in terms of availability of natural gas at reasonable natural gas pipeline tariff; incentivizing rapid development of natural gas pipeline infrastructure authorization process…

 bidding criteria (25 years economic life): lowness of PV of tariff bid for each year (70% weightage) highness of PV of natural gas volumes (in MMSCMD) proposed to be transported (30% weightage) Notes: tariff to be bid zone-wise (TZn >= TZn-1) with  40% weight for TZ1  20% weight for %age increase over first zone  10% weight for %age increase over TZ2 (constant % thereon) PV to be determined by using discount rate of 12% bids to be consistent with assumptions considered in approved DFR of project entity with highest composite score is successful

bidding process…illustrated Bid ABid BBid C TZIIIIIIIVVolTZIIIIIIIVVolTZIIIIIIIVVol Yr 10%80% Yr 15%90% Yr 0%100% 8%6.4% 14%12.2% 0%0.0% PV PV PV Tariff CriteriaVol Wt40%20%10%30% Bid ScoreTot A %80%578A45%0%10%27%82% B %90%637B40%0%9%30%79% C13.490%100%651C39%20%8%31%98% Min11.830%80%651 short & medium term: expected participation from gas producers only- guided by desires to timely reach markets to match gas monetization plans & surety on capacity utilization!

extra capacity provisions…  provision for extra capacity in natural gas pipeline to be made available for use as common carrier by any third party on open access & non- discriminatory basis  capacity of natural gas pipeline = A + B + C A.capacity requirements of entity (?) B.firmed-up contracted capacity with other entities C.at least 33% of (A) & (B) = extra capacity (?) should entity’s own requirement be clubbed with that of requirement of its own affiliate as well (provisions in PNGRB Act, 2006 does not envisage so; yet authorizations of some of pipelines do not suggest so…)

extra capacity provisions…  both government policy & PNGRB have same objective of having competitive gas markets – key is progressive unbundling along gas value chain  to create new authorization on ‘bundled basis’ only to be ‘unbundled’ later may have serious consequences in future  clubbing provision may have potential of serious monopoly abuse, in case authorized entity were to create an affiliate to be used as surrogate for blocking capacity booking by others  consumer may have only bundled contract option restricting it to either authorized entity or its affiliate  provisions in affiliate code of conduct may come in conflict when affiliate capacity requirements are to be assessed  section 21 of the PNGRB Act 2006 emphasizes need for fair competition & availability of natural gas

extra capacity provisions…  proviso to sub-section (1) of Section 21 of PNGRB Act, 2006 provides for application of provisions of affiliate code of conduct for separating activities of marketing from transportation of natural gas for pipelines  mention of ‘right of first use for its own use’ in sub-section (1) of section 21 of Act is with reference to an entity laying, building, operating or expanding a natural gas pipeline  further, definition of entity under sub-section p of Section 2 of Act implies that reference is to type or constitution of an entity & clearly an entity cannot and does not include its affiliate  therefore, it logically follows that assessment of ‘own capacity requirements’ of an entity does not envisage inclusion of capacity requirements of its affiliate

tariff determination tariff model: cost of service (discounted cash flow)  historical cost of assets to be considered on “rolling basis”  efficiently incurred capex & opex with linkage with capacity (existing pipeline capacity determination an issue ?) & operating parameters of pipeline: to be considered over economic life of project (replacements factored)  norms for capacity utilization & variable costs linked to actual throughput  returns linked to12% post-tax on capital employed (implying project funding & fund re-engineering flexibilities available)  infrastructure benefits u/s 80-IA allowed to be retained: shall incentivize pipeline investments  capital employed = net fixed assets (gross fixed assets less depreciation at SLM rates as per Companies Act + normative working capital (30 days of opex: at variance with product pipelines at 20 days during APM days’)

tariff determination tariff model: cost of service (discounted cash flow)  no change in tariff in case of capacity expansion by up to 10%  in case of capacity expansion >10%, entity to submit proposal to PNGRB & same may be allowed provided entity agrees to reduction in tariff by sharing fifty percent of proposed incremental tariff revenue calculated based on applicable tariff before expansion & incremental volumes  non-discriminatory charge of tariff & tariff to be reflected in invoice in energy equivalence terms (Rs./ MMBTU) making system more transparent from consumers’ standpoint  PNGRB, in medium term, should focus on evolving best standards & practices in pipeline laying, building & operations to enable development of benchmarks for efficient capex & opex in pipelines

tariff recovery system… potential disconnect 300 km each TZ 1TZ 2TZ 3TZ 4TZ 5 50 km band Interconnecting pipeline two-way gas flows physical impossibility- may result in unofficial swap positions inadvertently netback advantage could flow away from inter-connected pipeline into interconnecting pipeline resulting in:  pre-mature gas-to-gas competition  interconnecting pipeline opts for postalized tariff for entire pipeline length & customer closer to starting point suffers customer pays different tariffs based on gas source in same pipeline in same zone! new pipeline development gets adversely impacted as two-way gas flows cannot be envisaged in economics of pipeline design as volume flows may not be same in each tariff zone rationale of tariff recovery similar to a railway line where passenger getting-off closer to starting point does not want to pay fare for distance not traveled flexibility of volume variations in tariff zones allowed as pass-through in tariff principle based on “pay for distance traveled alone” may make inter-connection proposition unattractive for inter-connected pipeline….maybe tariff recovery system should be dynamic to gas grid concept & not vice-versa… Injection point

way forward…

some issues in way forward…  calibrated movement required (considering nascent stage of Indian gas market) from zonal postalized basis to full fledged entry-exit model for tariff recovery system, which is hallmark of most developed gas markets (Netherlands & U.K.)  regional network of pipelines may sometimes resemble CGD networks, yet CGD regulations cannot be applied due to legacy issues & impracticability, like, AGCL’s NE network of pipelines catering to small tea gardens; Charottar co-operative catering to small villages in an area along small industrial customers belt; Vadodra municipal corporation’s pipeline network catering only domestic PNG segment, etc.  applicability of tariff system yet to be articulated for regional network of pipelines, like GAIL’s pipeline network in KG basin

some issues in way forward…  monitoring mechanism for ensuring transparent contracting based on access code provisions  impact analysis of provisions of direct tax code on new natural gas pipeline projects  notification still awaited on regulations for basis of capacity determination for existing pipelines & declaration of pipelines as common carrier or contract carrier as envisaged in PNGRB Act, 2006 & in pipeline authorization regulations  thoughts on evolving trading platform for trading in pipeline capacity & gas supply contracts…

way forward for India… Ownership / Regulation State Monopoly Private Monopoly Emerging Competitive Liberalised Basic Emerging Sub-Mature Mature Market / Infrastructure possible alternative routes to be guided by degree of non-discriminatory access allowed to CC capacity effective unbundling of transportation & marketing activities …& during such period, adherence to ACOC provisions, regulatory maturity in handling complex access code issues & GOI’s forward looking policies shall be keenly followed by industry… Current

Thanks views contained in this presentation are expressed in personal capacity Vijay Duggal, DGM Commercial (CGD), BPCL