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Deregulation of the Canadian Natural Gas Market

The Deregulation of the Canadian Natural Gas Market: A Consumer Progress Report

This report examines the ongoing process of gas deregulation in Canada and evaluates the results from a consumer perspective. The report finds that while deregulation has the potential for efficiency gains and increase customer choice, the changes have brought about unanticipated results that have compromised the achievement of the sought after efficiency gains.

60 pages $20.00

Introduction

The international trend to introducing competition into industries such as energy and telecommunications that have traditionally operated as regulated monopolies, has been driven by numerous factors. Potential new entrants have recognized that regulatory change is a prerequisite for expanding their opportunities in regulated businesses. As a result, they have been prepared to invest heavily in reducing regulatory barriers to their activities. The incumbent regulated companies also have realized that deregulation creates significant opportunities, as well as risks, for them. Large customers often see deregulation as a means of enhancing their ability to exploit their “buying power” to obtain better prices in marketplace.

Regardless of the potential benefits motivating each interest group, the central theme of most of the arguments in support of deregulation is the potential for efficiency gains and increased customer choice. With these objective in mind, the regulatory environment within which these industries operate has been restructured, leading to significant transformations of the markets they serve. These changes, however, have brought with them unanticipated results that have compromised the achievement of the sought-after efficiency gains. It is now clear that deregulation can create a wide range of problems for industry players, regulators and consumers. The success of deregulation initiatives is therefore dependent on the ability of the deregulated ­ or re-regulated ­ industry to address the problems that arise.

Deregulation of the Canadian natural gas industry began with the elimination of the regulated well-head price for natural gas more than a decade ago. This change has led to increasing pressure for change in all sectors of the natural gas business, from transportation and distribution, to storage, and to retail services.

In order to anticipate the potential impacts of further deregulation, it is useful to consider the nature and historical evolution of the natural gas industry in Canada. Exploration of the US and Australian experiences are also helpful in this respect. Benefits of further change must be examined in light of potential adverse affects on sub-categories of consumers. In particular, low volume residential users may find further natural gas deregulation detrimental, especially if there are no practical mechanisms implemented to provide vital public goods that the competitive marketplace may not be able to provide effectively.

The Halloween Agreement of 1985

Prior to 1985, the commodity price of natural gas in Canada was set by agreements between the federal government and the Province of Alberta. Canadian gas prices were based on crude oil prices; local gas distribution companies (LDCs) in those provinces which had a gas supply had their rates and terms regulated by provincial regulatory boards.

A variety of political and economic reasons led to the formulation of the 1985 Western Accord on Energy Pricing and Taxation. The Accord led to the October 31st, 1985 Agreement on National Gas markets and Pricing (the Halloween Agreement). The Halloween Agreement was signed by the Government of Canada and by the Governments of the three major gas producing provinces in Canada namely, Alberta, British Columbia and Saskatchewan.

The differences in views on gas pricing between the federal government and the gas producing provinces prior to 1985, were considerable. At the centre of those differences was the Western Canadian opinion that gas pricing linked to crude oil not only deprived gas producers of the perceived price benefits of a competitive market, but distorted the economics of increased gas production. On the other hand, in the wake of the oil shocks of the mid-70’s the federal government was keenly aware of the interests of the large consuming provinces in market price of gas that was determined by the economics of natural gas in Canada rather than the economics of oil internationally.

Despite these conflicting motives, the four governments involved agreed that the creation of a more flexible, market-oriented gas price system would be in the interests of both the producing and the consuming provinces. The agreement eliminated regulation of gas commodity prices; the price would be determined instead in the competitive gas market that would develop as a result of the changes introduced by the Halloween Agreement.

The major participants in this new market were familiar; the gas producers in Alberta, BC and Saskatchewan; NOVA and Transgas still operated their intra-provincial pipelines and Trans-Canada Pipelines Ltd. (TCPL) still operated the major interprovincial pipelines. New players referred to as gas agents, brokers and marketers (or the acronym ABMs) entered the market, however.(1)

Prior to the Halloween Agreement, LDCs in Canada obtained the bulk of their gas supplies through long term contracts with TCPL. These contracts involved both the supply and transportation of gas from Western Canada to the LDC’s franchise areas. In that pre-1985 market no end user of natural gas, from industrial companies to individual residential customers, was able to arrange for and procure their own supplies of gas.

Thus, before the Halloween Agreement was struck, TCPL was the prime long-term supplier, transporter and seller of natural gas in Eastern Canada; the LDCs were under long term contractual obligations to TCPL both for their gas supply and their transportation requirements. Following the Halloween Agreement, gas customers in Eastern Canada had the ability to displace the LDCs’ volumes by purchasing their supplies directly. Initially, the financial penalties known as unabsorbed demand charges (UDCs) were levied by TCPL on LDCs’ short falls in the previously contracted long term contracts resulting from this displacement. In addition direct purchasers holding transmission capacity on TCPL were also liable for UDCs in respect of their short falls. Various decisions by the National Energy Board (NEB) and provincial regulatory boards alleviated this problem so as to enable direct purchases to displace LDC gas and transportation contracts without undue penalties.

Development of the Direct Purchase Market

Two principal forms of direct purchase have developed in the Post-Halloween Agreement phase. These are Transportation Service (T-Service) and buy sell agreements (buy-sell).

T-Service is generally used by larger users of natural gas such as industrial or large commercial companies, frequently with the assistance of consultants or agents who arrange for the direct customer to acquire gas, matching transportation over TCPL, and delivery to the customer’s premises by an LDC. Large customers utilize both “unbundled” T-service, by which the customer contracts for only for transportation of gas on TCPL and “bundled” T-service by which customers pay a transport rate with the addition of a bundled charge for all of the LDC’s service (including storage and load balancing) in connection with the transaction. In neither service is LDC gas is supplied to the customer. The availability of T-service has been of considerable economic importance in that it has allowed many large industrial customers to significantly reduce the prices they pay for natural gas.

Buy-sell arrangements involve customers, or their agents, purchasing gas in a producing province and selling it to their LDC at the LDC average cost of gas (the “buy-sell reference price”). By buying gas on shorter term supply arrangements than those of the LDCs, buy-sell customers were able obtain a better price in the market than was paid by the LDCs. The difference would cover the agents and provide a rebate to the buy-sell customer.

Buy-sell customers pay the same charges as all system (non-direct) customers of the LDC. However, their effective gas cost would be reduced by the rebate earned through the buy-sell transaction (i.e., a buy from a producer, combined with a sell at a higher price to the LDC).

Buy-sell arrangements are used by industrial and commercial customers who consider the requirements of T-service contracts to be too onerous for their circumstances. In addition, the near-universal arrangement for the aggregators serving small residential and commercial customers was the buy-sell. These arrangements, however, have had difficulties such as:

  1. aggregation through less than ethical door-to-door, telephone or direct mail techniques,
  2. reliance on misleading or insufficient information in signing up customers to contract terms that were typically five years or longer, and
  3. inefficient or insufficiently financed direct sellers.

These difficulties (and others) have been a source of concern to provincial governments and regulators. Regulators for example have required that certain consumer protection practices be incorporated into contracts to reduce irregularities in this area of direct selling.

From 1997 on, Ontario LDCs obtained approval from the OEB to operate a form of T-service that was practical for use in the small volume market. This service, known as ABC (agent billing and collecting) T-service has enabled ABMs to offer contracts that fix the price of gas at a level that is not related to the LDC’s cost of gas. The ABM pays a transaction fee in respect of the billing service to the LDC which identifies the direct seller by name and telephone number on the LDC portion of the bill in respect of gas costs. The LDC collects a gas charge that is set by the ABM from its customer and remits it to the direct seller. ABC service obviates the need for two bills (LDC for delivery & ABM for the commodity) being sent to a direct customers.

Regulatory bodies have used the introduction of ABC service to require increased customer protection measures and the inclusion of enhanced information about direct selling inserted in monthly gas billings.

The Challenges Ahead

The changes described above have allowed an increased degree of choice and flexibility within the market. Simultaneously however, they have resulted in the creation of a new set of problems for industry participants, regulators, and consumers. Change has therefore contributed to calls for more change which in turn will lead to a greater need for mechanisms to study and cope with the affects of shifting industry structure.

In particular, the shift from system supply to direct supply has given rise to the concern that a secure gas supply system might be compromised and that system benefits such as low income protection, universal access to service, environmental protection and energy efficiency will not be provided for within a competitive environment. This is a particularly thorny issue in light of calls for the exiting of LDCs from the merchant function, which would result in LDC’s no longer supplying gas (in addition to distribution services) as they do presently. Gas supply could be wholly competitive, with non-regulated affiliates of the LDC competing with other marketers following the LDC’s exit from its merchant function. There is a fear that the new industry participants lack the ability and the desire to work together so as to provide the public goods and services that the LDCs have maintained within a regulated environment. The potential LDC merchant exit and the proliferation of affiliate marketers also bring into play potential abuse of market power concerns. While the potential for LDCs to engage in cross subsidization, predation, cost shifting, and discriminatory self-dealing can be dealt with by regulators, the LDCs’ informational advantages such as brand name recognition, possession of customer databases and basic organization still give them that the advantages for the moment. Thus, even if the maximization of competition within the marketplace is viewed as a good in and of itself, the residual power of the LDCs raises the question as to whether a competitive environment can be created and sustained.

Even given the existence of effective competition, considerable doubts exist as to whether customers will have the ability to make informed choices in the marketplace. Available options are technical and confusing and there is a lack of effective consumer education programs which serve to deal with these problems. This basic problem raises issues concerning the need for marketing oversight agencies, codes of conduct, transparency and dispute resolution procedures.

These are not issues unique to Canada or specific to the natural gas industry. Deregulation of energy sectors is occurring in many countries. Indeed, it is impossible to study the course of industrial change with regard to natural gas without looking at developments within the electricity sector. After all, there is much talk of the idea of ‘convergence’, meaning that in the future energy and other services may be provided by mega-distributors using parallel networks. The rise in the number of mergers between energy marketers within North America may be viewed as a foreshadowing of this trend. Government regulators, industry groups, consumer organizations and individual consumers are all grappling with past change and the potential for more. This has led to the adoption of a variety of approaches in different countries, states and provinces. It is instructive to compare these approaches when assessing and evaluating options for the future.

Study Plan

Section One of this study examines how the industrial pressures created by pipeline access and pricing changes have been dealt with by different jurisdictions within Canada. In particular, experiences in Ontario and British Columbia are compared and contrasted. Section Two explores the federally mandated open access regime in the US as well as subsequent state unbundling and aggregation initiatives. The specific experiences of California, Ohio and New York are examined. Section Three provides a case study of the Australian natural gas industry, highlighting the implementation of a Commonwealth framework and the unbundling initiatives in the state of New South Wales.

The remainder of the paper focuses on consumer protection issues which are implicitly raised within Sections One – Three. In particular, problems surrounding the potential LDC exit from the merchant function are examined and the mechanisms for redress suggested by various jurisdictions examined and evaluated. Section Four focuses on the potential for market power abuse by industry ‘incumbents’ through cross-subsidization, cost shifting, discriminatory self-dealing and the exploitation of informational advantages. Section Five examines threats to system integrity through a discussion of the obligation to supply, non-discriminatory access, and supplier of last resort issues. Methods for the provision of demand side management and the maintenance of system benefits are explored. In light of these risks, predictions of consumer savings are examined and assessed. Section Six focuses on the protection of meaningful consumer choice within a more devolved natural gas industry. In particular, informational challenges and the control of ABM practices are examined. The impact of marketing oversight agencies, industrial codes of conduct, and standard form contracts are explored. Section Seven sets out the report’s conclusions in light of stakeholder views on future developments.

1. The term ‘agent’ refers to companies that arrange contracts on behalf of customers (i.e., acting as their agents). Brokers act as a middle-man, facilitating transactions between buyers and sellers for a brokerage fee. Marketers seek customers for producers or on their own behalf, to purchase gas. ABM’s frequently act as “aggregators”, so named because they aggregate either gas producers (supply aggregator) or gas end users (demand aggregator). In the present stage of development of the gas market, parties or companies supplying gas directly are often referred to as the ‘ABM’ sector of the market.

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