Maximum price for wholesale fuel-grade ethanol

Transcription

1 Maximum price for wholesale fuel-grade ethanol A report for Manildra Group 1 August 2016 HoustonKemp.com

2 Report Authors Greg Houston Brendan Quach Sarah Turner Contact Us Sydney Level Castlereagh Street Sydney NSW 2000 Phone: Singapore 12 Marina View #21-08 Asia Square Tower 2 Singapore Phone: Disclaimer This report is for the exclusive use of the HoustonKemp client named herein. There are no third party beneficiaries with respect to this report, and HoustonKemp does not accept any liability to any third party. Information furnished by others, upon which all or portions of this report are based, is believed to be reliable but has not been independently verified, unless otherwise expressly indicated. Public information and industry and statistical data are from sources we deem to be reliable; however, we make no representation as to the accuracy or completeness of such information. The opinions expressed in this report are valid only for the purpose stated herein and as of the date of this report. No obligations is assumed to revise this report to reflect changes, events or conditions, which occur subsequent to the date hereof. All decisions in connection with the implementation or use of advice or recommendations contained in this report are the sole responsibility of the client. HoustonKemp.com

3 Contents Executive Summary 1 1. Introduction 4 2. Australian fuel-grade ethanol market Suppliers of fuel-grade ethanol Purchasers of fuel-grade ethanol Supply of E10 to consumers Taxes and duties Market constraints on the price of ethanol Manildra faces strong constraints on the price of ethanol Manildra s ethanol prices vs import parity price Wheat and ethanol price analysis Current profitability of ethanol Ethanol mandate Ethanol mandate Achievement of the ethanol mandate Implications of a maximum wholesale price Multiple feedstocks Cost based maximum price for fuel-grade ethanol Conclusion 31 HoustonKemp.com

4 Figure Figure 2.1: Summary of the flow of ethanol and E10 in Australia 5 Figure 2.2: Location and capacity of the current and prospective producers of fuel-grade ethanol 8 Figure 2.3: Estimated cost of transport between wholesalers and producers 10 Figure 2.4: Sales of ethanol-blended fuel by state between January 2016 and May Figure 3.1: Manildra ethanol average prices and indicative import parity price 18 Figure 3.2: Change in Manildra ethanol prices and wheat prices (Index Jan 2011=100) 19 Figure 3.3: Change in Manildra ethanol prices and terminal gate RULP prices (Index Jan 2011=100) 20 Figure 4.1: Implied wholesale and retail margin on fuel-grade ethanol between January 2010 and June Figure 4.2: Difference between the average retail price of RULP and E10 in NSW between January 2010 and June Tables Table 2.1: Proposed ethanol plants in Australia 7 Table 2.2: Known major fuel wholesalers that purchase ethanol 9 Table 2.3: Rate of duty payable on domestically produced fuel-grade ethanol 13 Table 5.1: Efficient production of ethanol using different feedstocks (illustration) 28 Table 5.2: Cost based maximum price for ethanol (illustration) 29 HoustonKemp.com

5 Executive Summary Executive Summary We have been asked to prepare this report by Manildra Group Ltd (Manildra). The context of our report is the review by the Independent Pricing and Regulatory Tribunal (IPART) of a maximum price for wholesale ethanol in automotive fuel blends. 1 IPART has been tasked by the NSW Premier to investigate and recommend: 2 a maximum price for wholesale ethanol for use in automotive fuel blends; and/or a price methodology that ethanol suppliers must apply to determine a maximum price when selling wholesale ethanol for the purposes of complying with the Act [Biofuels Act 2007] and regulation. In deciding on a maximum price IPART is to have regard to: (a) protecting consumers from potential abuses in monopoly power relating to prices (b) the efficient costs of supply ethanol (c) any other matters the Tribunal considers relevant We have been asked to comment on IPART s review, including its assumption that Manildra has substantial market power, and to assess the potential effect of setting a maximum price for wholesale fuel-grade ethanol. Market constraints on the price of ethanol The NSW government s decision to impose a maximum price for wholesale fuel-grade ethanol stems from IPART s finding in May 2015 that Manildra has substantial market power in the ethanol market. In this report, IPART did not disclose any detailed reasoning or empirical analysis by way of support for its contention, other than listing the four observations, ie: Manildra is the only producer and dominant supplier of ethanol in NSW and volume fuel sellers must purchase ethanol to comply with the mandate; the price of ethanol is higher than the international price; and Manildra s cost of supplying ethanol is likely lower than its Australian competitors; and there is little prospect of competition from imported ethanol in the foreseeable future. Our analysis shows that, when examined carefully, IPART s finding does not stand up to close scrutiny principally because it does not take sufficient account of the strong constraint imposed by the ready availability of close substitutes for ethanol blended fuels. The relevant constraint on Manildra s prices is neither its own costs nor those of its rival producers, but rather the price of close substitute, pure petroleum-based fuels, ie, the various forms of ULP. The constraint provided by the existence of such close substitutes is demonstrated every time a motorist compares the prices of different types of fuel available at any fuel retail station, and selects one to fill their vehicle. The frequency and regularity of such consumption decisions and the ease of switching between one form of fuel 1 Throughout this report we refer to ethanol used in automotive fuel blends as fuel-grade ethanol. 2 IPART, Review of a maximum price for wholesale ethanol in automotive fuel blends Issues paper, June 2016, p 41. HoustonKemp.com 1

6 Executive Summary (eg, E10) and another (eg, unleaded petrol) imposes a strong constraint on the retail price of E10 in the form of the price of unleaded petrol. IPART s analysis also overlooks the implications of the modest transport costs differences for potential supply of ethanol by non-nsw producers. The cost to transport ethanol interstate is relatively low, with our analysis indicating that the transport cost differential as between that faced by Manildra and that faced by Dalby for the supply of ethanol to Sydney fuel terminals from Queensland is just five cents, and just two cents for supply to Newcastle fuel terminals. 3 These transport cost differences amount to between approximately three and seven per cent of the current market price of the product itself. When set against the usual threshold of between five and ten per cent for application of the hypothetical monopolist test used to establish the scope of meaningful competitive constraints, these transport cost differentials are sufficiently low to invite the conclusion that the geographic dimension of the market is not confined to NSW, but rather spans the eastern states. Further, IPART s observation that volume fuel sellers must purchase ethanol to comply with the mandate implies that the constraint that might otherwise be imposed by the price of the close substitute (ie, unleaded petrol) is undermined by the mandate. Such an implication is not valid because the practical reality of the mandate is that although volume fuel sellers must offer E10 fuel for sale at their retail outlets, the mandate does not and cannot extent to a requirement that any particular motorist must purchase any particular amount of E10. The existence of the mandate has no bearing on a retail customer s decision as to fuel type, beyond the requirement that motorists must be presented with a choice. Put simply, the mandate is incapable of undermining the strong retail price constraint imposed on the price of ethanol blended fuel. Further, there are a number of significant new producers of fuel-grade ethanol in various stages of planning in both NSW and Queensland. This suggests that there are few barriers to entry by new suppliers. The prospect of substantial new entry can also be expected to continue to constrain the ability of current producers to raise prices above a workably competitive level, even as demand for wholesale fuel-grade ethanol lifts to meet the combined NSW and Queensland mandates. In addition, our analysis of historical fuel prices suggest that fuel-grade ethanol producers have not exercised substantial market power because Manildra s average ethanol price: is substantially lower than the import parity price, suggesting that domestic prices are constrained by a range of factors including competition from other Australian ethanol producers, countervailing buyer bargaining power and the ability of consumers switch from E10 to other unleaded petrol types; is uncorrelated to the cost of the wheat, which is the feedstock used to produce ethanol, and so is inconsistent with the pricing strategy of a profit maximising firm with substantial market power; and which again is inconsistent with the expectations of a profit maximising firm with substantial market power. Use of a maximum price to achieve the ethanol mandate Setting a maximum price for wholesale fuel-grade ethanol will not increase the uptake of fuel-grade ethanol if lower wholesale prices of ethanol are not passed on to consumers. There are two distinct decision makers that lie between ethanol producers and consumers; namely, fuel wholesalers and fuel retailers. The price that fuel wholesalers charge retailers for E10 includes a wholesale margin over the costs of wholesale regular ULP and wholesale fuel-grade ethanol. The price that motorists pay to fuel retailers includes a retail margin over the wholesale price charged by fuel wholesalers. 3 See section HoustonKemp.com 2

7 Executive Summary Data obtained by us data show that the implied wholesale and retail margin on fuel-grade ethanol in NSW has been increasing steadily over the five year period since January Although they show some variability form month to month, the trend in these data suggest the extent of the increase in the combined margin is in the order of 25 per cent, ie, from around 21 cents per litre to around 26 cents per litre. At the same time as the combined retail and wholesale margin has been increasing, the difference between the average retail price of regular ULP and E10 at those NSW retail sites where both fuels are sold has been decreasing. Again, although the data do vary from month to month, the results of our analysis show that the price differential at which E10 is offered to motorists as compared with regular ULP has reduced from a discount of around 2.8 cents per litre to around 1.5 cents per litre. On its face, our analysis suggests that the reducing price differential between regular ULP and E10 and the associated decline in sales of E10 is a consequence of increased wholesale and/or retail margins, as opposed to increases in the relative price of wholesale ethanol. In any case, the results of our analysis suggest that any downward adjustment to the wholesale price of fuelgrade ethanol brought about through the introduction of a binding maximum price will not necessarily flow through to lower retail prices for E10. Naturally, if reductions in the wholesale price of fuel-grade ethanol are not followed by lower retail prices of E10, and subsequent increases in the sales of E10, then any maximum price for wholesale fuel-grade ethanol will not assist in achieving the mandate. Implications of a maximum price If ethanol producers do not have the ability to exercise substantial market power, then a maximum price provides no additional consumer protection. However, a maximum price does have the potential to do significant damage competition in the ethanol production market. The principal risk is that a maximum price is likely to prevent ethanol producers from recovering their total costs. In section 5 we show there is a material risk that any form of cost based maximum price will not allow an efficient producer recover the cost of producing ethanol. Such an arrangement would substantially damage competition and consumer outcomes in the fuel-grade ethanol production market. The absence of any evidence that ethanol producers possess any market power, together with the real risk that a maximum price may damage competition in the ethanol production market, suggest that IPART s first recommendation should be that a maximum price is unnecessary. In the event that IPART must nevertheless develop a maximum price and/or pricing methodology, it should be designed so as to have no impact on the current market arrangements. To that end, we note that an import parity price (including taxes and excise) would be consistent with a first do no harm intervention in the ethanol production market. HoustonKemp.com 3

8 Introduction 1. Introduction This report has been prepared by HoustonKemp at the request of Manildra Group Ltd (Manildra). The context of our report is the review by the Independent Pricing and Regulatory Tribunal (IPART) of a maximum price for wholesale ethanol in automotive fuel blends. 4 As part of its review, IPART has been asked to recommend: 5 a maximum price for wholesale ethanol for use in automotive fuel blends; and/or a price methodology that ethanol suppliers must apply to determine a maximum price when selling wholesale ethanol for the purposes of complying with the Act [Biofuels Act 2007] and regulation. In deciding the relevant maximum price and/or price methodology, IPART is to have regard to: 6 (a) protecting consumers from potential abuses in monopoly power relating to prices (b) the efficient costs of supply ethanol (c) any other matters the Tribunal considers relevant IPART s review follows an amendment to the Biofuels Act 2007 to extend the ethanol mandate to a wider range of service stations and to provide for IPART to regulate the price of wholesale ethanol to support availability of E10 at petrol stations at an attractive price to customers. 7 We have been asked to assess the potential effect of a possible maximum price for wholesale fuel-grade ethanol, as well as to determine the most appropriate method for calculating the maximum wholesale price. We have structured our report as follows: in section 2 we describe the Australian fuel-grade ethanol market, including a description of the sellers and buyers of fuel-grade ethanol and of the ethanol blended automotive fuel E10, as well as the taxes and import duties that apply to these fuels; in section 3 we review the basis for the conclusion drawn in IPART s May 2015 report that Manildra has substantial market power in the ethanol market, and show that this finding does not stand up to close scrutiny, and explain why the constraints that apply to the pricing of Manildra s fuel-grade ethanol mean that it has no market power; in section 4 we describe the operation of the ethanol mandate and explain that setting a maximum price for wholesale ethanol is unlikely to assist in achieving the mandate; in section 5 we discuss approaches to determining a maximum price canvassed by IPART that involve rely on an analysis of cost of production to determine the maximum price of fuel-grade ethanol; and in section 6 we conclude. 4 Throughout this report we refer to ethanol used in automotive fuel blends as fuel-grade ethanol. 5 IPART, Review of a maximum price for wholesale ethanol in automotive fuel blends Issues paper, June 2016, p IPART, Review of a maximum price for wholesale ethanol in automotive fuel blends Issues paper, June 2016, p Terms of reference, Maximum price for wholesale ethanol in NSW, 10 May HoustonKemp.com 4

9 Australian fuel-grade ethanol market 2. Australian fuel-grade ethanol market The Australian fuel-grade ethanol market is characterised by domestic ethanol producers supplying fuel wholesalers with fuel-grade ethanol, who then mix the ethanol with regular unleaded petrol (regular ULP) to create E10 for on sale to fuel retailers, and then motorists. Figure 2.1 below summarises the flow of fuelgrade ethanol through the Australian fuel industry. Figure 2.1: Summary of the flow of ethanol and E10 in Australia Notes and sources: The above diagram does not incorporate any reference to fuel transport costs. We understand that ethanol producers typically pay to transport ethanol to fuel wholesalers, and that the cost to transport fuel (including E10) from fuel wholesalers to fuel retailers are a matter of commercial negotiation and may be paid by either party. Icons made by Freepik from IPART has been asked to review the price of wholesale fuel-grade ethanol in NSW, which, as illustrated in Figure 2.1, is the price that ethanol producers receive for fuel-grade ethanol sold to fuel wholesalers. A maximum wholesale price for fuel-grade ethanol may influence the supply of ethanol. For example, if the maximum price was set too low, then this could result in an undersupply of ethanol in NSW. Fuel wholesalers and retailers both add a margin to the price of wholesale fuel-grade ethanol, and the price that consumers pay for E10 includes these two margins. In other words, beyond the price paid for wholesale supply of fuel-graded ethanol, two additional participants in the vertical supply chain determine the price that HoustonKemp.com 5

10 Australian fuel-grade ethanol market consumers ultimately pay for E10. It follows that, even if IPART was to set a maximum price that caused the current price of wholesale fuel-grade ethanol to be reduced, this reduction may not be fully passed through to the price paid by motorists for E10. In the remainder of this section we describe the sellers and buyers of fuel-grade ethanol and E10, and the taxes and import duties that apply to these fuels. 2.1 Suppliers of fuel-grade ethanol In this section we describe the current and prospective suppliers of fuel-grade ethanol in Australia Current producers of fuel-grade ethanol There are three producers of fuel-grade ethanol in Australia, one of which is located in New South Wales (Manildra) while the remaining two are located in Queensland (Wilmar BioEthanol and Dalby BioRefinery). These three producers manufacture ethanol from different feedstocks and are predominantly located in the regions where the feedstock is sourced in order to optimise the total cost of transporting both feedstock and the ethanol that is produced, and to ensure ready availability of feedstocks. 8 In particular: Manildra produces ethanol from wheat starch at a plant located near Nowra, NSW. Manildra is the largest producer of fuel-grade ethanol in Australia, 9 with a capacity of 300 million litres of ethanol per year; Wilmar BioEthanol is Australia's largest producer of sugar-based ethanol. 10 Wilmar BioEthanol produces its ethanol by fermenting molasses, a by-product of sugar production. The plant is located in Sarina, QLD and produces 60 million litres of ethanol per year, with a capacity to produce 90 million litres annually; 11 and Dalby BioRefinery, owned by United Petroleum, is Australia's first grain to ethanol plant. 12 Dalby BioRefinery purchases red sorghum and converts it to fuel-grade ethanol. The plant is located in Dalby, QLD and produces 76 million litres of ethanol per year from red sorghum, with the biorefinery expected to produce more than 76 million litres of fuel-grade ethanol each year at full capacity. 13 All fuel-grade ethanol consumed in NSW is currently supplied by Australian producers. 14 However, Australia accounts for only a small proportion (approximately 0.3 per cent) of global ethanol production, with the US and Brazil being the two largest producers of fuel-grade ethanol, at 58 per cent and 29 per cent of global output, respectively. 15 Australia s small contribution to global fuel-grade ethanol production indicates there is potential for Australia to import fuel-grade ethanol in the future however, imported ethanol is subject to customs duties (see section 2.4 below). 8 IPART, Ethanol supply and demand in NSW, March 2012, p Manildra website, accessed 18 July Queensland Government, Department of Energy and Water Supply, and Queensland Government, Department of State Development, Queensland Biofutures 10-Year Roadmap and Action Plan, June 2016, p Wilmar website, accessed 11 July 2016; and Queensland Government, Department of State Development, Queensland Biofutures 10-Year Roadmap and Action Plan, June 2016, p 5; and Biofuels Association of Australia, BAA Chairman weighs in on Queensland ethanol mandate, 16 June 2015, accessed 29 July Queensland Government, Department of Energy and Water Supply, and Queensland Government, Department of State Development, Queensland Biofutures 10-Year Roadmap and Action Plan, June 2016, p United Energy website, and accessed 11 July 2016; and Queensland Government, Department of State Development, Queensland Biofutures 10-Year Roadmap and Action Plan, June 2016, p IPART, Ethanol mandate Options to increase the uptake of ethanol blended petrol, May 2015, p IPART, Ethanol mandate Options to increase the uptake of ethanol blended petrol, May 2015, p 24. HoustonKemp.com 6

11 Australian fuel-grade ethanol market Prospective producers of fuel-grade ethanol In addition to the above three ethanol plants, a number of domestic fuel-grade ethanol plants are in the planning stages of development, namely: North Queensland Bio-Energy (NQBE) NQBE is planning the construction of a $520 million sugar (raw & white), ethanol and power generation facility in Ingham, North Queensland. 16 The plant will produce between 90,000 litres and 250,000 litres of ethanol per day; Dongmun Greentec Dongmun Greentec is proposing to construct and operate an ethanol plant at Deniliquin, NSW. 17 The ethanol plant will process up to 300,000 tonnes of low grade locally grown wheat grain to produce up to 115 million litres of fuel grade ethanol per annum. 18 The project was recently approved by the Department of Planning & Environment, and is proposed to be constructed over a 14 to 16 month period; 19 Renewable Developments Australia the Australian Renewable Energy Agency (ARENA) has provided funding for Renewable Developments Australia to develop a detailed business case for an $800 million renewable bio-energy plant. 20 The plant would be able to produce up to 350 million litres of fuel grade ethanol per year using purpose-grown feedstock (sugar cane and sweet sorghum). 21 The project is aiming to be lowest cost ethanol producer in the world; and Austcane Energy Austcane Energy is proposing to construct Australia s first dedicated sugar cane feedstock ethanol distillery. 22 The proposed plant would produce approximately 100 million litres per year of fuel-grade ethanol. The project involves a capital investment of $240 million over a scheduled 24 month construction timeframe, 23 with a possible commissioning The table below summarises the above proposed ethanol plants. Table 2.1: Proposed ethanol plants in Australia Name Location Feedstock Annual capacity Status North Queensland Bio- Energy Ingham, QLD Sugar million litres to million litres Expected to commence operations in June 2018 Dongmun Greentec Deniliquin, NSW Wheat Up to 115 million litres On 1 July 2016, the Department of Planning & Environment approved the Deniliquin Ethanol Project Renewable Developments Australia Pentland, QLD Sugar cane and sweet sorghum Up to 350 million litres The business case is due for completion by November 2016 Austcane Energy Mona Park, QLD Sugar cane Approximately 100 million litres Possible commissioning in NQBE website, accessed 18 July NSW Government, Planning & Environment, Environmental assessment report Deniliquin Ethanol Plant, June 2016, p iv. 18 Dongmun Greentec website, accessed 18 July Dongmun Greentec, Deniliquin Ethanol Plant: Environmental Impact Statement Volume 1, October 2015, p i. 20 Minister for the Environment, Media release: Australia s largest bio-energy project a step closer to reality, 29 April 2016, accessed at 21 Minister for the Environment, Media release: Australia s largest bio-energy project a step closer to reality, 29 April 2016, accessed at and Renewable Developments Australia website, accessed on 18 July Austcane website, accessed 18 July Austcane website, accessed 18 July Department of Energy and Water Supply, Queensland, Queensland Biofuels Pathway, 18 September 2015, p 5. HoustonKemp.com 7

12 Australian fuel-grade ethanol market We depict the location and capacity of the current and prospective producers of fuel-grade ethanol in the Figure 2.2 below. Figure 2.2: Location and capacity of the current and prospective producers of fuel-grade ethanol 2.2 Purchasers of fuel-grade ethanol In this section we describe the purchase of fuel-grade ethanol by wholesalers, and the sale of E10 to retailers. HoustonKemp.com 8

13 Australian fuel-grade ethanol market Fuel wholesalers Fuel-grade ethanol producers sell their product to fuel wholesalers, whose role is to receive, store and blend ethanol and other fuel products and distribute them to retailers. 25 In addition to selling ethanol to fuel wholesalers, ethanol producers also export a relatively low volume of fuel-grade ethanol. For example, exported ethanol accounted for of Manildra s total ethanol production in The fuel wholesale sector of the Australian automotive fuel industry consists principally of the four refinerwholesalers 26 and large independent wholesalers, such as Ausfuel, Liberty, Neumann Petroleum and United. 27 The refiner-wholesalers account over 90 per cent of wholesale petrol sales volumes, as monitored by the Australian Competition and Consumer Commission (ACCC) in However, not all fuel wholesalers purchase fuel-grade ethanol, and we understand that only a select number of wholesalers purchase fuel-grade ethanol in NSW, QLD and VIC see Table 2.2 below. Table 2.2: Known major fuel wholesalers that purchase ethanol Wholesaler Delivery site State BP c/- Viva Terminal Parramatta NSW BP c/- Vopak Site B, Port Botany NSW BP BP Newcastle Terminal NSW BP BP Brisbane Terminal QLD BP BP Mackay Terminal QLD Viva energy Viva Terminal Parramatta NSW Viva energy Viva Newcastle Terminal NSW Viva energy Viva Newport Terminal VIC Viva energy Viva Pinkenba Terminal QLD Mobil/Caltex c/- Vopak Site B, Port Botany NSW Mobil/Caltex Silverwater Terminal NSW Mobil/Caltex c/- BP Carrington (Newcastle) NSW Mobil/Caltex Yarraville Terminal VIC Ethanol producers mix their ethanol with regular ULP at the point of dispatch by tanker from their plant, typically at a ratio of ethanol to regular ULP of 99 to Denatured ethanol is then transported to the wholesalers terminals for storage these terminals may be owned and operated either by individual wholesalers or in joint-venture with another wholesaler, or by a third-party. 30 Ethanol producers typically pay 25 ACCC, Monitoring of the Australian petroleum industry, December 2010, p The ACCC defines a refiner-marketer as a company that refines, imports, wholesales fuel; in Australia these are BP, Caltex, Mobil and Shell. See ACCC, Monitoring of the Australian petroleum industry, December 2014, p xvii. 27 ACCC, Monitoring of the Australian petroleum industry, December 2014, p ACCC, Monitoring of the Australian petroleum industry, December 2014, p Ethanol is mixed with a small portion of another chemical so as to make the ethanol non-potable. This is known as denatured ethanol. EnergyQuest, Benchmarking the price of Fuel Ethanol in Australia Report to Australian Competition and Consumer Commission, July 2010, p Australian Institute of Petroleum website, accessed 20 July HoustonKemp.com 9

14 Australian fuel-grade ethanol market for cost of transporting their ethanol to the wholesaler s terminal, with this cost increasing with distance. 31 For example, Manildra supplies wholesalers in NSW, QLD and VIC, and incurs costs of between approximately $0.03 per litre and $0.17 per litre to transport fuel-grade ethanol from its plant near Nowra to wholesalers located in these three states. 32 Ethanol producers located closer to wholesale terminals have a locational advantage over rival producers however, as we explain in section 3.1 below, the costs are transport are not so significant as to preclude producers from competing to supply the same wholesale terminal. We have estimated the costs for each of the three operating ethanol producers to transport ethanol to the various wholesale locations listed in Table 2.2 above, and set these out in Figure 2.3 below. Figure 2.3: Estimated cost of transport between wholesalers and producers Notes and sources: Spreadsheet provided by Manildra, entitled Terminal addresses freight rate; and HoustonKemp analysis. Transport costs for Dalby and Wilmar are estimated by first calculating a linear regression equation of Manildra s transport costs and the distance transported, and then applying this equation to estimate the approximate transport costs. We illustrate in Figure 2.3 that the estimated cost for ethanol producers to transport their product to various fuel wholesalers ranges between $0.02 and $0.17 cents per litre (cpl). 31 Caltex is an exception to this, with this retailer picking up ethanol from Manildra s Nowra site. 32 It costs Manildra approximately $0.03 to transport ethanol to Port Botany, NSW a distance of approximately 160 km. Comparatively, Manildra pays approximately $0.17 per litre to transport ethanol to Mackay, QLD a distance of approximately 1,900 km. Source: Spreadsheet provided by Manildra, entitled Terminal addresses freight rate. HoustonKemp.com 10

15 Australian fuel-grade ethanol market Manildra has the lowest transport costs for ethanol sold to NSW and VIC fuel wholesalers known to purchase ethanol, and the highest transport costs to ship to Queensland fuel wholesalers known to purchase ethanol. However, the cost advantage for Manildra, as compared with the next closest producers is just five cents per litre for Sydney-based fuel wholesalers, and two cents per litre for fuel wholesalers located in Newcastle Retailers Wholesalers mix ethanol with regular ULP in tankers to form E10 and then sell this to specialist fuel retailers (including independents and supermarkets), refiner-wholesaler branded retailers, and resellers and distributors. 33 Specialist retailers account for the largest percentage of wholesale sales of petrol, purchasing over 60 per cent of refiner-wholesalers wholesale petrol in However, not all fuel retailers purchase E10, which is sold at approximately 55 per cent of NSW service stations. 35 E10 currently accounts for 19 per cent of fuel nozzles across all NSW service stations Supply of E10 to consumers NSW, Queensland and Victoria are the only Australian states that sell a significant volume of E10, with NSW accounting for the majority of E10 sales NSW represented approximately 80 per cent of the total E10 sales in Australia in Figure 2.4 below depicts the volume of E10 sold in NSW, VIC and QLD in the first five months of Figure 2.4: Sales of ethanol-blended fuel by state between January 2016 and May 2016 Sales of ethanol-blended fuel (kl) 140, , ,000 80,000 60,000 40,000 20,000 0 Jan-16 Feb-16 Mar-16 Apr-16 May-16 NSW VIC QLD NSW is currently the only Australian state imposing a mandate on the supply of ethanol blended fuels, with this likely to be driving the higher sales of E10 in NSW relative to other states. However, on 1 December 2015 the Queensland parliament passed the Liquid Fuel Supply (Ethanol and Other Biofuels Mandate) Amendment Act 2015 to set targets for the sale of ethanol blended petrol and bio-based diesel in 33 ACCC, Monitoring of the Australian petroleum industry, December 2014, pp ACCC, Monitoring of the Australian petroleum industry, December 2014, p IPART, Ethanol mandate Options to increase the uptake of ethanol blended petrol, May 2015, p This figure represents the average for 4Q 2015 and 1Q Service station data collection results July ACCC, Quarterly report on the Australian petroleum industry February 2016, p 20. We note that the ACCC s sales values include the sales of other fuels blended with E10 (eg, E85), however, the sales of ethanol blends other than E10 are minimal. HoustonKemp.com 11

16 Australian fuel-grade ethanol market Queensland. 38 The Queensland mandate requires that three per cent of the total volume of petrol sales must be ethanol and is due to start on 1 January The Queensland act also provides that the ethanol mandate will increase to four per cent after 18 months, ie, from 1 July Once commenced, this mandate can be expected to increase availability and stimulate demand for E10 in Queensland. The demand for E10 is also be influenced by consumers perception as to the value of ethanol blended fuels. Both NSW and Queensland are proposing to run education campaigns to inform consumers of the benefits of ethanol and dispel existing myths surrounding the fuel. 40 For example, consumers may be unaware that many petrol vehicles run better on E10 because of its higher research octane number (RON) relative to regular ULP, as well as related environmental benefits. 41 A recent study by University of Melbourne Professor Brear 42 found that the fuel consumption of a vehicle running on E10 was one per cent lower than the fuel consumption of the same vehicle running on regular ULP 43 where fuel consumption is defined as the number of litres of fuel required for a car to travel 100km so that the lower the number of litres stated, the better the fuel economy. 44 Professor Brear also identified a number of positive externalities associated with the use of E10 relative to regular ULP, such as lower emissions of carbon dioxide, unburnt hydrocarbon and oxides of nitrogen Taxes and duties Prior to 1 July 2016, the effective excise on ethanol was zero. This arrangement was given effect under the Ethanol Production Grants Program (EPGP), under which domestic ethanol producers received a full excise reimbursement for ethanol produced and supplied for transport use in Australia. The EPGP commenced in September 2002 and was introduced for the purpose of supporting production and deployment of ethanol as a sustainable transport fuel in Australia. 46 The intended outcome of the EPGP was to: 47 (a) Encourage the use of environmentally sustainable fuel ethanol as an alternative transport fuel in Australia; (b) Increase the capacity of the ethanol industry to supply the transport fuel market; and (c) Improve the long term viability of the ethanol industry in Australia. 38 Queensland Minister for Main Roads, Road Safety and Ports and Minister for Energy and Water Supply, Media statement: Biofuels mandate powers sustainable future, 1 December 2015, au/statement/2015/12/1/biofuels-mandate-powerssustainable-future, accessed 20 July Queensland Government, Department of Energy and Water Supply website, accessed 20 July NSW Government, Finance, Services and Innovation, Media release: Reforms To Biofuels Mandate To Boost Competition And Transparency, 20 December 2015, available at: and Queensland Minister for Main Roads, Road Safety and Ports and Minister for Energy and Water Supply, Media statement: Biofuels mandate powers sustainable future, 1 December 2015, accessed 20 July Biofuels Amendment Bill 2016, Bill introduced on motion by Mr Victor Dominello, Second Reading: Mr Victor Dominello, 16 March 2016, RON is a measure of the efficiency of petrol at resisting engine knocking. In Australia, grades of petrol typically include RON 91 (regular) and RON 95 and higher (premium grades). ACCC, Monitoring of the Australian petroleum industry, December 2013, p xxii. 42 Professor Michael Brear runs the University s contribution to the Advanced Centre for Automotive Research and Testing (ACART). See 43 Professor Michael Brear, University of Melbourne / ACART, Comparison of emissions and fuel consumption of a passenger vehicle on two fuels, pp CarsGuide website, accessed 23 July Professor Michael Brear, University of Melbourne / ACART, Comparison of emissions and fuel consumption of a passenger vehicle on two fuels, pp Australian Government, Department of Industry, Ethanol Production Grants Program, Program administration guidelines, June 2014, p Australian Government, Department of Industry, Ethanol Production Grants Program, Program administration guidelines, June 2014, p 3. HoustonKemp.com 12

17 Australian fuel-grade ethanol market The EPGP ended on 1 July 2015, and, in the same month, the Australian government passed the Excise Tariff Amendment (Ethanol and Biodiesel) Act This act reduced the rates of excise duty for domestically manufactured fuel-grade ethanol and biodiesel to zero for a one year period commencing 1 July 2015, with the rate of excise duty for domestically manufactured fuel-grade ethanol increasing annually on 1 July of each subsequent year until the final rates are reached on 1 July The excise rate is determined as a percentage of the rate that applies to petrol, and is to be increased from zero to per cent of the petrol excise rate. Table 2.3 below sets out the rates that apply in each financial year. Put another way, domestic ethanol producers will continue to receive a discount on the excise rate applicable to petrol of at least per cent. Table 2.3: Rate of duty payable on domestically produced fuel-grade ethanol Financial year commencing Fuel-grade ethanol excise rate (percentage of the rate that applies to petrol) Excise rate based on the current petrol excise of 39.5 cpl 1 July % 0.0 cpl 1 July % 2.6 cpl 1 July % 5.2 cpl 1 July % 7.8 cpl 1 July % 10.4 cpl 1 July 2020 or a later 1 July % 12.9 cpl Source: Excise Tariff Amendment (Ethanol and Biodiesel) Act 2015, Schedule 1. The petrol excise rate is currently set at 39.5 cpl and is subject to periodic indexation for changes in consumer prices. 50 In particular, the fuel excise rate increases twice a year, typically in February and August, in line with movements of the Consumer Price Index. 51 Imported fuel-grade ethanol is subject to both a general tariff of 5 per cent (unless the imports are from the USA) and a customs duty equal to the excise rate on petrol 52 which, as noted above, is currently set at 39.5 cpl Parliament of Australia website, accessed 20 July Parliament of Australia website, accessed 20 July ACCC, Quarterly report on the Australian petroleum industry June 2016, p The Australian Government introduced biannual indexation in 10 November ACCC, Quarterly report on the Australian petroleum industry June 2016, p Australian Government, Rural Industries Research and Development Corporation, Biofuels in Australia, November 2007, p Excise Tariff Amendment (Ethanol and Biodiesel) Bill 2015, Explanatory memorandum, para Australian Government, Department of Immigration and Border Protection, indexation of customs duty rates on excise-equivalent goods on 1 February 2016, p 4. HoustonKemp.com 13

18 Market constraints on the price of ethanol 3. Market constraints on the price of ethanol In this section, we review the basis for the conclusion drawn in IPART s May 2015 report that Manildra has substantial market power in the ethanol market, and show that this finding does not stand up to close scrutiny. We explain the constraints that apply to the pricing of Manildra s fuel-grade ethanol mean that it has no market power, which is confirmed by comparisons we undertake of Manildra s fuel-grade ethanol prices over the past five years to international benchmarks, import parity prices and the cost of its wheat feedstock. 3.1 Manildra faces strong constraints on the price of ethanol The NSW government s decision to impose a maximum price for wholesale fuel-grade ethanol stems from IPART s finding in May 2015 that: 54 Manildra Group has substantial market power in the ethanol market with the ethanol mandate: It is the only producer and dominant supplier of ethanol in NSW and volume fuel sellers must purchase ethanol to comply with the mandate. The price of ethanol in NSW is higher than the international market price. Manildra Group s cost of supply is likely lower than its Australian competitors given its integrated production process, which includes using a waste product. There is little prospect of competition from imported ethanol in the foreseeable future, given the Australian Government s concessionary excise arrangements for local ethanol producers Beyond these cursory statements, IPART did not disclose any detailed reasoning or empirical analysis by way of support for this contention in its May 2015 report. Notwithstanding, IPART s earlier finding has established the presumptive outcome for its current review, that the wholesale price of ethanol should be subject to regulation as to its maximum price. In our opinion, the reasoning set out by IPART is insufficient to draw such a significant conclusion in relation to the pricing of ethanol by Manildra (or any other ethanol producer). Rather, the application of conventional principles and reasoning of competition analysis provides strong evidence that Manildra has no ability or incentive to raise the price of fuel-grade ethanol above a workably competitive level. By way of context, any conclusion as to the existence of substantial market power amounts to a finding that a producer is able to set its prices that are free of the normal constraints of effective competition. In the frequently cited observation of the landmark judgment of the High Court in Queensland Wire Industries Pty Ltd v BHP, the court explained the concept of market power in terms of behaviour as distinct from price : 55 A firm possesses market power when it can behave persistently in a manner different from the behaviour that a competitive market would enforce on a firm faring otherwise similar cost and demand conditions. 54 IPART, Ethanol mandate Options to increase the uptake of ethanol blended petrol Other Final Report, May 2015, p Queensland Wire Industries Pty Ltd v Broken Hill Pty Co Ltd [1989] HCA 6; (1989) 167 CLR 177 (8 February 1989), Judgment of Dawson, J. at 5. HoustonKemp.com 14

19 Market constraints on the price of ethanol Consistent with this, in in Boral Besser Masonry v ACCC, the High Court emphasised that the existence of market power implied the absence of constraint: 56 The essence of power is absence of constraint. Market power in a supplier is absence of constraint from the conduct of competitors or customers.matters of degree are involved, but when a question of the degree of market power enjoyed by a supplier arises, the statute directs attention to the extent to which the conduct of the firm is constrained by the conduct of its competitors or its customers. In making the observations we cite above, IPART appears to have adopted a similar course of reasoning, by focusing on the extent of constraints applying to Manildra s sale of ethanol. However, a fundamental shortcoming with each of the observations made by IPART is their limited focus, so that potential constraints on the price of ethanol are derived only by reference to alternative producers or sources of ethanol. For example, IPART observes that: Manildra is the only producer in NSW; the price of ethanol is higher than the international price; and Manildra s cost of supplying ethanol is likely lower than its Australian competitors. These observations overlook the constraint on the price of ethanol imposed by Manildra s customers, who are in turn constrained by the ready availability of very close substitute fuel products, in the form of unleaded petrol. The constraint provided by the existence of such close substitutes applies each and every time a motorist compares the prices of different types of fuel available at any retail outlet, and selects one or other to fill his or her tank. The frequency and regularity of such consumption decisions and the ease of switching between one form of fuel (say, ethanol blended E10) and another (unleaded petrol) imposes a strong constraint on the retail price of E10 in the form of the price of unleaded petrol. In its first stated reason by way of support for the contention that Manildra has substantial market power, IPART observes that volume fuel sellers must purchase ethanol to comply with the mandate. IPART leaves the implication that, somehow, the constraint that might otherwise be imposed by the price of the close substitute unleaded petrol is undermined by the mandate. Such an implication is not valid. The practical reality of the mandate is that volume fuel sellers must offer E10 fuel for sale at their retail outlets. 57 However, the mandate does not and cannot extent to a requirement that any particular motorist must purchase any particular amount of E10. Although E10 must be made available, the ultimate determinant of the quantity sold is a combination of customer preferences and the price of E10 relative to its close substitute, unleaded fuel. The existence of the mandate has no bearing on a retail customer s decision as to fuel type, beyond the requirement that motorists must be presented with a choice. Put simply, the mandate is incapable of undermining the strong retail price constraint imposed on the price of ethanol blended fuel. In our opinion, IPART s broad observation as to role of the mandate overlooks these practical realities, and leads to an error in its implication that, because fuel wholesalers must purchase some ethanol, they are captive purchasers of particular quantities of ethanol, at an inflated price. Rather, for all practical purposes, fuel wholesalers need only to purchase as much ethanol as required to meet retail demand for E10 (at those outlets covered by the mandate). 56 Boral Besser Masonry Ltd v ACCC [2003] HCA 5; 215 CLR 374; 77 ALJR 623; 195 ALR 609; 77 ALJR 623 (7 February 2003) at Although the mandate is expressed in terms of an obligation on volume sellers of petrol to ensure that ethanol comprises six per cent of all petrol sold, a volume seller can defend a prosecution by showing it took all reasonable steps to comply with the mandate. Of these steps, the most tangible is the requirement to ensure the availability of facilities to sell ethanol blended fuel at each retail service station controlled by it. See IPART, Ethanol mandate, May 2015, pp HoustonKemp.com 15

20 Market constraints on the price of ethanol Further, wholesalers and retailers are themselves in a strong position to determine the demand for E10 by the pricing decisions they make, the end result of which is the price presented to customers at the retail fuel pump. The existence of a strong constraint on the retail price of E10, in combination with the need for wholesalers and retailers to earn sufficient margin on E10 for it to be priced so as to compete with unleaded fuel, means that the retail price constraint on E10 translates directly into an equally strong constraint on the wholesale price of ethanol. In other words, Manildra simply cannot set its price for ethanol above the level necessary for: wholesalers and retailers to earn a margin that is not less than would be earned in alternative fuel; and retailers to set a price for E10 that will elicit demand for the product (and so for its ethanol component). In our opinion, this reasoning alone is sufficient to establish that Manildra has no ability or incentive to raise the price of ethanol above that which ensures E10 can compete on its merits with other fuels. The principal reasons for the very different conclusion drawn in its May 2015 report is that IPART has overlooked the strong constraint imposed on the retail price of E10 by alternative competing fuels, and the need for wholesalers and retailers to earn sufficient margin on E10 for them to offer it at competitive price. Notwithstanding this overwhelming consideration, each of the additional observations made by IPART by way of support for its conclusion that Manildra holds substantial market power also bear comment. Taking these in turn: 1. Manildra is the only producer of ethanol in NSW. Although this observation is accurate in its own terms, it does not establish either that NSW fuel wholesalers have no choice as to supplier of ethanol or that all E10 sold in NSW is supplied by fuel wholesalers located in NSW. The analysis we present in Figure 2.3 above shows that the transport cost differential as between that faced by Manildra and that faced by Dalby for the supply of ethanol to Sydney fuel terminals from Queensland is just five cents, and just two cents for supply to Newcastle fuel terminals. These transport cost differences amount to between approximately three and seven per cent of the current market price of the product itself. When such transport cost differentials are set against the usual threshold of between five and ten per cent for application of the hypothetical monopolist test used to establish the scope of meaningful competitive constraints, 58 they are sufficiently low to invite the conclusion that the geographic dimension of the market is not confined to NSW, but rather spans the eastern states. 2. The price of ethanol is higher than the international market price. IPART does not provide any detailed analysis by way of support for this observation. The relevant international price for testing the extent to which a domestic market may be subject to competition from international suppliers is the import parity price. In section 3.2 below we show below that the wholesale price of ethanol as received by Manildra over the past five years is systematically below the import parity price for ethanol. 58 We note that the ACCC uses a 5 per cent SSNIP test (see: ACCC, Merger guidelines, November 2008), while other regulators, ie, in the European Union competition law adopt a 5-10 per cent SSNIP range (see: Official Journal C 372 of , available at HoustonKemp.com 16