VIEWPOINT

Gas transportation - a comment on BG’s consultative paper

Catherine Price

The regulation of British Gas (BG) has

become increasingly explicit during the five years since privatization. The most recent move has been the splitting of BG into separate subsidiaries, one of which, gas transportation, will sell its

services on the same basis to BG’s gas supply as to competitors transporting gas. BG are required to undertake a

public consultation about the charging methodology, and this note comments on their consultative document.’ It

concludes that though BG subscribes to admirable principles it uses these to

obscure rather than display appropri-

ate cost messages to users.

Keywords: Gas; Access; Pricing

Catherine Price is at the Department of Economics, University of Leicester, Leicester LEl 7RH. UK.

‘Gus Transportation: A Public Consulta- tion Document, published by British Gas, London, UK, 1992. *Ofgas, 1991 Annual Report, HMSO, Lon- don, UK, 1992. ‘Monopolies and Mergers Commission, Gas, Command paper 500, HMSO. Lon- don, UK, 1988. “British Gas, op tit, Ref 1.

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British Gas (BG) was the second major UK utility to be privatized, in 1986. It was sold as a vertically and horizontally integrated industry, buying gas from North Sea producers at the beach-head and delivering to final consumers throughout the UK. Domestic and small industrial and commercial consumers are supplied on a tariff, consisting of a basic stand- ing charge and running rate which is geographically uniform; (lower rates and seasonal factors have recently been introduced for ‘large’ tariff con- sumers). Very large demands (over 25 000 therms per year) were original- ly supplied under individually negoti- ated and confidential contracts and more recently under published price schedules.

The distinction between tariff and contract supplies also defined a divi- sion in the regulators role. Price cap regulation was applied to the tariff sector where the monopoly of gas supply was legally protected. In con- trast the ‘contract’ sector was not sub- ject to explicit regulation, despite the absence of gas-to-gas competition, and the regulator had a duty to en- courage the development of competi- tion. Since BG owned all the pipelines this required access to these pipes for potential competitors. In fact such access had been legally possible since 1982, but no ‘third party’ gas was carried until the next decade.

The form of BG’s privatization, as a monopoly sold intact with very light regulation to maximize share sales proceeds, was much criticized. The regulator* maintains that such pessi-

mism was inappropriate since the structure for effective regulation was present, as its development has shown. Regulation has certainly been more extensive and effective than many commentators predicted in 1986.

A Monopolies and Mergers Com- mission (MMC) report” in 1988 estab- lished that there was abuse in the (non-regulated) contract sector. This resulted in three measures to encour- age competition: the publication of price schedules which were not subject to negotiation; the reservation of 10% of new supplies for potential competi- tors; and the publication of detailed charges for third party carriers. The Office of Fair Trading (OFT, like the MMC a general competition body) was to review the success of these measures after three years.

In the event the OFT findings were disappointing; although third party contracts had been signed these were mainly for the new electricity genera- tion market, and impinged little on the established ‘contract’ market. As a result of this report, negotiations re- sulted in BG’s reluctant agreement in early 1992 (under threat of another MMC referral) to split its gas trans- portation and distribution system into a separate subsidiary which would charge to other parts of BG the same rates as applied to ‘third parties’. BG agreed to consult on the pricing methodology for such transport, and the document under discussion is the first stage in that public consultation.”

The paper is a welcome consultation by BG with its customers and other

UTILITIES POLICY October 1992

6 it is essential that the ioss of differentiation of prices is carefully monitored, so that its effect is clear. ’

UTILITIES POLICY October 1992 331

interested parties. This present re- sponse is from a somewhat more de- tached view, and comments both on principles and on implementation.

Principles

The criteria for judging various regimes is clearly set out. Some are straight forward - eg that gas trans- portation recovers its costs (and a suggested 4.5% return on assets), and that economic efficiency and efficien- cy of implementation require simple and appropriate cost messages. How- ever, the remaining categories, equita- bility and acceptability to shippers are less clear. At one point (5.1.2) the paper maintains that equitability is not relevant ‘since it is a prerequisite of any system that it should be applicable to all shippers’ while at various points later (eg 5.1.4 and 5.3.3) equity is sometimes used as an important criteria - apparently somewhat selec-

tively. The explicit treatment of economic

efficiency is particularly welcome, and its identification (ideally) with long- run marginal cost (LRMC) pricing especially so in an industry which has long eschewed this concept. In discus- sing the problems for cost recovery (especially severe with transportation) the paper mentions only Ramsey (uni- form) pricing, but in fact produces price schedules based on quantity transported, ie multipart tariffs. Since this is to be recommended in principle as superior to Ramsey pricing BG has missed an opportunity to take credit for their proposed solution.

There are potential conflicts be- tween all of the criteria, and BG rec- ognizes these, drawing attention in the last paragraph of 5.1.4 to a particular problem of recovering costs when charging marginal cost prices. Indeed the difficulty may be even worse than suggested, since recovering costs from markets which will adjust their de- mand least may well mean raising prices above marginal costs to those who have least alternative. However, the solution suggested in this case (that equity dictates more overheads recovered through volume costs) is not justified. BG needs to present a much more explicit model of equity if it is to draw such specific conclusions.

Charging options

Viewpoint

The choice of a ‘simplified LRMC’ pricing system seems appropriate; LRMC would certainly need to be simplified in some way to give under- standable messages about costs. How- ever LRMC is a misnomer if, rather than simplifying costs, the prices de- liberately misrepresent them. This is explicit in the division between capital and current costs (paragraph 6.3.3) where BG estimates that capital costs account for 70% of marginal cost but decides, apparently quite arbitrarily, to make the split 50:50. Sending the wrong cost messages has no merit at all.

This misallocation has particular im- plications for interruptible gas, which bears no peak costs. By attributing more costs to the commodity element, this raises the apparent absolute cost of interruptible gas, and raises its rela- tive cost still further by depressing the cost of peak consumption. This intro- duces further distortion into the pric- ing mechanism.

Some error in pricing is bound to appear from the necessary simplifica- tion of marginal costs. However, the particular method used, ‘collapsing’ the distance element into entry and exit charges (presumably based on average distances to and from each point), further weakens the ability of the charging sytem to give appropriate signals. For the main long-run ‘cost- driver’ is undoubtedly distance, with separate site charges made to cover some of the off-take costs. If this element is eliminated through averag- ing, the resultant tariff bears very little relation to the marginal costs which it purports to represent.

In particular, the ‘cost absorption’ currently practised (whereby those close to gas supplies pay more than costs of supply while those with long supply lines are subsidized) will be emphasized under this scheme. This is not desirable on efficiency grounds, and incidentally coincides with the sys- tem which maximizes profit (by a form of price discrimination since prices do not reflect costs). However, the motivation for abandoning distance related carriage rates is much more likely to be the new requirement that BG charge itself and others for gas

‘The suggested charges appear to be the outcome of profit maximization and protectionism rather than any serious attempt to meet the criteria for efficiency or equity. ’

‘Catherine Price, ‘Privatisation and regula- tion - the effect on the UK gas industry’, Department of Economics, discussion pap- er, University of Leicester, UK, 1YYl.

transport on the same basis. BG has consistently resisted pressure to differ- entiate either contract or tariff prices by location. By disguising the distance element through input and off-take charges in the prices it will have to charge its own gas supply division, it enables continued obfuscation of this element. This would clearly not pro- duce messages conducive to economic efficiency. Moreover there must be some fear that individual regions may eventually be split from each other (on the electricity industry pattern). In this case the charges for different off- takes will be crucial in determining the profitability of each region. Much more explicit detail on the determina- tion of charges is required. This would be helped by continuing the practice introduced in September 1991 of pub- lishing the formula on which the prices are based rather than merely illustra- tive charges.

If BG is to proceed on the basis which it proposes, it is essential that the loss of differentiation of prices is carefully monitored, so that its effect is clear. This should be agreed be- tween BG and Ofgas, perhaps on the basis of the (unpublished) joint cost allocation undertaken in 1991.

Comparison with independent cost estimates

Independent cost estimates’ indicate that the present access charges are very close in level to estimated margin- al costs. However, their structure sug- gests that too little was allocated to peak consumption, and that BG demonstrate cost absorption (charging too much to consumers close to a beach-head and too little to those dis- tant) in typical profit maximizing be-

haviour. These proposed changes emphasize these distortions still fur- ther, moving BG back towards total cost absorption, ie uniform pricing. This is a retrograde step and very disappointing if allowed to proceed. It certainly bears little relation to econo- mic efficiency or the other criteria so grandly expounded (for the first time) by BG. We must deduce that these were introduced either to impress or confuse the reader (or both) and do not seem to have informed BG’s sug- gested pricing methodology. It would be interesting to have comparisons of profit under each regime to supple- ment the comparative price figures. The suggested charges appear to be the outcome of profit maximization and protectionism rather than any se- rious attempt to meet the (laudable) criteria for efficiency or equity.

BG’s consultative letter refers to this as a measure to encourage de- velopment of self-sustaining competi- tion. These proposals as such do not counter the development of such com- petition, though the competition would be inappropriate (eg would be likely to supply inappropriate geo- graphical regions, those distant from a beach-head because transport costs are undercharged). Competition is likely to require as paramount condi- tions stability and predictability. The pricing system is also transparent, in that the charges are predictable (though this would be much improved by publishing the basis as well as illus- trative charges). However, the advan- tages of both these characteristics are lost if the transparent messages are wrong (indeed some opacity might be welcome to reduce their effect) so that the competition is inappropriate.

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