The Regulatory Framework of the GB Gas Market Anjli Mehta, Senior Economist, Wholesale Markets 26/06/14

Contents Privatisation and Liberalisation Ofgem Statutory Duties Regulation of Wholesale Markets Regulation of Network

Privatisation and Liberalisation Ofgem Statutory Duties Regulation of Wholesale Markets Regulation of Network

Transportation (TransCo) separated GB gas market 1986 - 2000 Competition deregulation Monopoly Industrial/commercial competition Network Code – single contract Domestic competition roll out New trading market British Gas demerger – storage and E&P British Gas privatisation Time Transportation (TransCo) separated 1986 1990 1996 1997 1996-98 1999 2000 1995

Privatisation and Liberalisation Gas Act 1986 Enabled privatisation of British Gas and created regulatory framework. No differentiation between supplier of gas and operator of transmission system. British Gas only authorised supplier for consumers < 25,000 therms (732 MWh) / year. Competition for consumption > 25,000 therms (732 MWh) / year (“large consumers”) 1988 MMC report Reference to MMC (Monopolies and Mergers Commission) for large consumer market. Concluded many large consumers had no realistic alternatives to British Gas, and evidence of price discrimination. As a result – British Gas required to price by reference to published schedules. Also undertook to contract for no more than 90% of any new supplies from UK continental shelf in the period June 1989 – May 1991. 1991 OFT review Review for large consumer market. Found 1988 remedies had been ineffective in introducing self-sustaining competition in large consumer market. Particular obstacles – lack of available gas for competing suppliers, British Gas’s monopoly of supply to smaller consumers and position in storage and distribution British Gas gave series of undertakings – creation of conditions so other suppliers should be able to supply at least 60 % of large consumers by 1995; and separation of transportation and storage activities, with published transparent charges. Gas release programmes to give competitors access to supplies. Combined with independent production from new fields supported development of competition.

Privatisation and Liberalisation 1991 Lowered statutory monopoly to consumers < 2,500 therms (73 MWh) / year. Further gas release programmes. 1993 MMC report References to MMC on pricing methodology for transportation and storage, and tariff formula for smaller consumers. Main recommendations for separation of transportation and storage from gas supply, regulation of transportation and storage using RPI-X system and eventual introduction of competition for all consumers. Removal of remaining supply monopoly on a phased basis 1996-1998 Gas Act 1995 Set out framework for roll-out of domestic competition Set up licensing regime for gas transporters, suppliers and shippers (and transporters not permitted from holding shippers or suppliers licences) Led to separation of BG (as transporter and storage operator, plus upstream E&P) and British Gas Trading(as shipper and supplier) 2000 - 2005 British Gas Trading spun-off as Centrica BG demerged Lattice group (transporter and storage operator) Storage moved outside Transco “ring-fence” Lattice group merged with National Grid (Electricity TSO)

Gas industry structure Privatised with previous structure fully intact Lacked competitive pressure Widely considered a mistake of gas privatisation. Required 3 competition enquiries and number of years for completive gas market to emerge Electricity liberalisation introduced more competitive structure from outset – particularly splitting on transmission assets from generation and supply

Ofgem Role Privatisation and Liberalisation Ofgem Role Regulation of Wholesale Markets Regulation of Network

Ofgem Statutory Duties Office of Gas and Electricity Markets (OFGEM) Regulatory independence Principle Objective: to protect the interests of present and future consumers Regulation of network monopolies Promotion of competition Other statutory duties Support the development of a low carbon economy Take into account the European dimension of all our activities Regard to Security of Supply

Hierarchy of Law EU Law (including European Network Codes) GB Primary Legislation (Gas Act 1986, Gas Act 1995, Utilities Act 2000, Energy Acts…) GB Secondary Legislation Licences (eg Gas Supplier Licence) Industry Codes

Gas markets and networks New Challenges and Responsibilities Low Carbon Transition Gas markets and networks Smart Grids Local generation Energy efficiency District heating Fuel poor CCS European Network Codes LNG Renewable gas / Shale gas Uncertain demand Decline in domestic production Ageing assets Affordability Security of supply 11

Independence Regulator set up at privatisation – Ofgas. Recognition that shareholders needed confidence that government would not “meddle” in British Gas European Third Package formalised independence further - National Regulatory Authority (NRA) Be independent from any public or private entity and act independently from any market interest Take autonomous decisions, independently from any political body in relation to its functions as the designated NRA Not seek to take direct instructions from any Government or other public or private entity when carrying out the regulatory tasks set out in the Directive

Regulation of Wholesale Markets Privatisation and Liberalisation Ofgem Statutory Duties Regulation of Wholesale Markets Regulation of Network

Contractual framework Licences (LEGISLATIVE) Gas transporter licence Shipper licence Supplier licence Uniform Network Code (UNC) (INDUSTRY/NGG) Governs relationship between gas transporters and shippers Provides a level playing field Charging statements Statement of Transmission Transportation Charges Indicative/confirmed Gas transporter not allowed to hold shipper / supplier licence

Industry Players Producer Consumer Transmission (NTS) Distribution Xoserve Shipper Supplier Financial Flow Gas Flow

Unbundling models Independent System Operator (ISO) Unbundling aims to avoid conflicts of interest and to make sure that transmission system operators ("TSOs") take their decisions independently, ensuring transparency and non-discrimination towards all network users. European legislation defines models for unbundling Ownership Unbundling (OU) Applicant must pass 5 tests set out in the GA/EA Tests look at who the applicant has shareholdings or other rights in, who has such rights in the applicant (and their other holdings and appointments) and who is a director or the applicant (and their other holdings and appointments) Derogation Applicant’s transmission system must have belonged to a vertically integrated undertaking (i.e. a corporate group involving transmission and production/supply) (VIU) on 3 September 2009 AND arrangements must guarantee more effective independence of the TSO than the ITO model below Independent System Operator (ISO) For gas applicants only I.e. where the TSO has appointed an independent system operator, who agrees to comply with the requirements of the Third Package Directive on ISOs Must be approved by the Commission

Unbundling models Independent Transmission Operator (ITO) Only available to interconnector applicants Applicant’s transmission system must have belonged to a VIU on 3 September 2009 Applicant must show how it meets the ring-fencing requirements of the Third Package Directives on areas such as: (i) assets, equipment, staff and identity; (ii) independence of the TSO; (iii) independence of staff and management; (iv) supervisory body; (v) compliance programme and officer; and, (vi) network development and investment Second and Third Package Exemptions Interconnector licensees only Applicant holds an exemption (e.g. from third party access) and remains entitled to the benefit of it Ground only applies for the duration of the exemption If partial exemption, must be ring-fencing in relation to non-exempt capacity

Uniform Network Code UNC objectives: The legal contract between transporters and shippers, that defines the operation of the gas regime, providing “level playing field”. Key elements are: Definition of players Capacity (access to the system) Energy balancing (system clearing) Gas trading Emergency procedures Supply point administration (customer management) Invoicing and credit UNC objectives: Efficient and economic operation of the pipe-line system Coordinated, efficient and economic operation of the combined pipe-line system, and/ or the pipe-line system of one or more other relevant gas transporters Efficient discharge of the licensee's obligations Securing of effective competition between relevant shippers, between relevant suppliers; and/or between DN operators and relevant shippers. Provision of reasonable economic incentives for relevant suppliers to secure that the domestic customer supply security standards… are satisfied as respects the availability of gas to their domestic customers Promotion of efficiency in the implementation and administration of the Code Compliance with the Regulation and any relevant legally binding decisions of the European Commission and/or the Agency for the Co-operation of Energy Regulators

How do these translate in practice? Storage Regulation Main objectives Facilitate new investment Support commercial use of storage Promote competition in the gas market How do these translate in practice? Third party access exemptions Minor facility exemptions (majority of storage facilities in GB) Large infrastructure exemptions (none) Default regime Negotiated third party access (Rough and Hornsea) Additional requirements Rough Undertakings

How do these translate in practice? LNG Regulation Main objectives Facilitate new investment Support use of LNG import capacity Promote competition in the gas market How do these translate in practice? Third party access exemptions Large infrastructure exemptions (all existing facilities: Isle of Grain 1-3, Dragon, South Hook) Default regime Regulated third party access (none at the moment)

The European Dimension European Network Codes Ofgem’s Role Contribute to development of codes including leading some of them Provide advice to government who lead on legislation Lead some regional initiative projects Implement the codes Work with relevant bodies – eg ACER etc… The Third Energy Package - aims to facilitate greater cross-border trade and improve efficiency of wholesale markets in Europe through greater integration and a common set of market rules. Why are we doing this? – legal obligation, security of supply, protecting GB and EU consumers Progress Made – some price convergence, but more work to be done, i.e. Gas not always flowing to where it is most valued Network Codes – developed to formalise rules across Europe, which TSOs are obliged to adhere to, to realise the objectives of the Third Energy Package

The EU gas target model Legally binding European legislation Hub 2011 gas target model of the Council of European Energy Regulators (non-binding) Recommendation 1: creating liquid wholesale markets (e.g. creating entry exit zones) Recommendation 2: Connecting markets (improve efficiency of how markets interact) Recommendation 3: Investment (e.g. incremental capacity auctions) Legally binding European legislation Congestion Management Procedures Overselling and buyback, use it or lose it Capacity Allocation Network Code Auctions, bundled products Gas balancing Network Code Cash-out, market based balancing Interoperability Network Code Data exchange Transmission tariff structures Network Code Charging rules, reserve prices

Regulation of Network Privatisation and Liberalisation Ofgem Statutory Duties Regulation of Wholesale Markets Regulation of Network

Incentive regulation Network companies are engineering, asset based natural monopolies Unregulated can increase price and lower quality A price control is a limit on the amount of revenue that companies can collect over the course of the price control period allowed revenues are adjusted by inflation (RPI) and an X factor that represents anticipated efficiency gains (or cost increases) Companies are incentivised to beat the regulators’ assumptions If they do, they keep the benefit until the next price control At next control, consumers benefit Quality measures Sustainable delivery Lower costs for consumers First price control review Second price control review

It has delivered significant benefits for consumers: ‘RPI-X’ regulation of energy networks We have used RPI-X as a basis for regulating energy networks for about 20 years It has delivered significant benefits for consumers: Reductions in network charges Improvements in operating efficiency More efficient financing Improved quality of service Increased Investment But the framework may have led to: Networks focused on short term Networks focused on Ofgem not customers Limited consideration of innovation and how best to deliver Potentially limited appetite for risk Bias for ‘capex’ solutions rather than non-network options Limited focus on ‘cross- sectoral’ interactions RPI-X was not broken but a new “fit for purpose” framework was needed 25

RIIO: A new approach to regulation Constraint set up front to ensure: Revenue Timely and efficient delivery Network companies are financeable Transparency and predictability Balance between costs faced by current and future consumers = Deliver outputs efficiently over time with: Incentives 8 yr control Rewards/penalties for delivery Upfront efficiency rate + Technical and commercial innovation encouraged through: Innovation Core price control incentives Option to give third parties a greater role in delivery Innovation stimulus package + Outputs set out in clear ‘compact’, reflecting expectations of current and future consumers Outputs 26

Key elements of RIIO Developed with customers influence at all stages Comprehensive customer focused outputs Focus on sustainable delivery and longer term value for money 8 year control Business plan sets 8 years in longer context 8 year control Supports innovation though with additional mechanisms Network Company allowed and encouraged to take more initiative Well justified business plan rewarded during setting of price control and beyond Company leads justification for efficient plan – makes case for regulatory review Retains successful features of incentive regulation – upfront incentives/sharing investment costs between current and future consumers through the regulatory asset value approach – efficient approach to financing costs