KPK SAS State, National and International Regulatory Regimes K Peter Kolf Director KPK Specialist Advisory Services Pty Ltd Oil and Gas Markets 660 Curtin Graduate School of Business 26 July 2010

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KPK SAS Overview Part 1 Background on KPK About regulation About economics Part 2 Economics and Law Issues in regulation relevant to oil and gas o Project Discovery, Ofgem, UK o Inquiry into domestic gas prices

KPK SAS 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

KPK SAS What is Regulation? A law, regulation, rule, code or policy ‒ (with or without the coercive power of the law)

KPK SAS 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

KPK SAS 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)

KPK SAS 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)

KPK SAS Instruments of Regulation Legislation ‒ Statutes (inflexible) Subsidiary legislation ‒ Regulations, codes, rules (less formal, interpretation problems ) Industry codes of practice ‒ (enforceability problems)

KPK SAS Why Have Regulation? Contain activity within prescribed bounds Marry private interest with public good Issues of: o Objectives o Effectiveness o Efficiency o Unintended consequences o Incentives o Motivation

KPK SAS Efficiency Effectiveness Good regulation Inefficient regulation (Resources are wasted, eg overly prescriptive regulation) Ineffective regulation (Using price to regulate activity where P ε d is low) Bad regulation (WA’s Reservation Policy)

KPK SAS Some Economics Economic Efficiency  Productive efficiency  Allocative efficiency  Dynamic efficiency (long run) –Singularity –Inefficient trading arrangements waste resources –Does not address the distribution of income or wealth

KPK SAS Commodity 1 Commodity 2 Interests of Consumers Optimum Production Possibility Frontier Technical Efficiency

KPK SAS Objective Function Maximise: Long term interests of consumers Subject to: Meeting environmental objectives Interests of investors & service providers Re-elect Minister

KPK SAS Commodity 1 Commodity 2 Election of Minister Interests of Consumers Interests of Investors Continuous voting by consumers through market Allocative Efficiency

KPK SAS Commodity 1 Commodity 2 Optimum Max π Interests of Consumers π= α Dynamic Efficiency

KPK SAS 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

KPK SAS Supply of Goods & Services Private Goods Bread, butter etc Mixed Goods Pipelines, wires etc Public Goods Free to air, defence etc Common Property Goods Fisheries, resources (oil, gas, water etc) Rivalry Not Excludable No Rivalry

KPK SAS Normative Properties - Economics Self interest Public interest Preferences Cultural traditions Beliefs Social standards Teachings

KPK SAS 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)

KPK SAS 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)

KPK SAS 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

KPK SAS Economics 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)

KPK SAS Issues in Regulation Project Discovery, Ofgem, United Kingdom 0to%20Project%20Discovery%20- %20Options%20for%20delivering%20secure%20and%20sustainable%20energy%20supp lies.pdf Inquiry into domestic gas prices, Western Australia tees+-+Inquiries

KPK SAS 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.

KPK SAS 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

KPK SAS Project Discovery, Ofgem, UK Issues: o Observes 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? o Don’t underestimate importance of adaptability o Project discovery introduces risk and uncertainty with possible self fulfilling consequences.

KPK SAS Project Discovery, Ofgem, UK Issues: o What are the unintended consequences of project discovery’s scenarios? o What 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?) o Are issues concerning the functioning of the capital market relevant to the energy market?

KPK SAS Project Discovery, Ofgem, UK Issues: o Who is responsible for ensuring energy security - government or the private sector? o What is the risk and cost of centralised intervention proving to be unwarranted?

KPK SAS Inquiry: Domestic Gas Prices WA A legislative Assembly Committee (The Economics and Industry Standing Committee) was directed to inquire into: o measures that could be implemented to reduce the price of natural gas in Western Australia

KPK SAS The Problem Gas for the domestic market in short supply Causes: o East Spar field watering in o Varanus Island disruption o Domgas processing capacity limits (both NWSG & Varanus Island) o Historical low contract gas prices led to concentration in upstream market to two main domgas suppliers o LNG producers short of feed stock (Wheatstone, Pluto) o Upstream cost escalation – the low hanging fruit has been picked o Tight and unconventional gas costly - WA lacks technology

KPK SAS The Options Regulatory or market fix, or both? o Use it or lose it retention lease policy o Reservation policy o Separate gas marketing o Government imposed secondary gas market – is proposed o Centralised State gas aggregator o State or national oil company o Perth LNG import terminal o Government to fund tight and unconventional gas exploration and development o Broaden gas quality spec. – in progress

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

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

KPK SAS Quantity The Price of Natural Gas Cost / Price ($/GJ) Wellhead cost Netback price Domestic commodity price Alternate fuel price (Opportunity cost) Negotiation - P ε d

KPK SAS All Ordinaries and S&P/ASX-200 Indexes Source: Australian Securities Exchange web site, 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

KPK SAS The 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.

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

KPK SAS 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