NWT GAS PRICE REGULATION PRELIMINARY INVESTIGATION PREPARED BY: 4808 SCHOOL DRAW AVENUE, YELLOWKNIFE, NT (867)

Transcription

1 NWT GAS PRICE REGULATION PRELIMINARY INVESTIGATION PREPARED BY: 4808 SCHOOL DRAW AVENUE, YELLOWKNIFE, NT (867) SEPTEMBER 2013

2 NWT GAS PRICE REGULATION Preliminary Investigation September 2013 EXECUTIVE SUMMARY The general purpose of regulation is to protect businesses and consumers from market failures and safeguard social and environmental values. In response to public concern about high gasoline prices in the NWT, the GNWT sought the services of an independent consultant to investigate whether there was merit in implementing GNWT regulation of the price of gasoline (and possibly other fuels) in NWT communities served by privately-owned fuel distributors and retailers. It should be noted that this investigation did not have access to the annual fuel sales, operating expenses or level of profitability of these businesses as this information is not publically available. To provide background and context, information was gathered on the Canadian fuel markets (refining, distribution and retailing), the various fuel price regulatory systems in place in other Canadian jurisdictions and the structure and size of the retail fuel market in the NWT that is served by private businesses. A review of the fuel price regulatory systems in operation elsewhere in Canada (i.e. PEI, New Brunswick, Nova Scotia, Newfoundland and Labrador and Quebec) indicated that there are at least four different public policy objectives (or reasons) for considering fuel price regulation. Two of these objectives (related to the minimization of fuel price volatility and the protection of smaller service station operators from predatory pricing practices by larger operators) did not appear relevant for the NWT. The objectives that may be of interest to NWT policymakers include ensuring that consumers pay just and reasonable prices (or alternatively the lowest possible prices) while ensuring the availability of supply throughout the territory and promoting fairness and transparency in how retail fuel prices are set. The analysis conducted examined the available evidence to try to determine whether there is merit in pursuing these latter objectives in NWT communities served by private businesses (i.e. excluding the 16 communities served by the GNWT s Petroleum Products Division). Three specific market characteristics were considered. The first characteristic of interest is the market structure and extent of competition that exists. Of the approximately 37 fuel retailers that comprise the market, only 3 appear to be operating as the sole fuel retailer in their community and without any competition in the general vicinity (i.e. Aklavik, Fort Liard and Fort Resolution). All other service stations have at least one other competitor in their community or general vicinity. The amount of fuel sold by these retailers is estimated at about 52.5 million liters per year 40 million liters of gasoline and 12.5 million liters of diesel. Most of these retailers appear to be operating as independents (i.e. no affiliation with a major oil and gas company or refinery) and are selling between 500,000 to 1,000,000 liters per year which is very low compared to typical service stations in Canada. A review of monthly average prices for regular unleaded gasoline in Yellowknife confirms that the price has remained virtually unchanged at $1.39 per liter over the last eighteen (18) months (small changes in price over a few days may be masked by monthly averages). By contrast, the price of gasoline ranged from $1.26 to $1.48 per litre in Whitehorse and from $1.19 to $1.35 per liter across the rest of Canada. The lack of price variation for gasoline in Yellowknife suggests that retailers there have little incentive to compete with each other for market share, either because they are typically making very little profit and can t afford any price wars or because they are making very healthy profits and are content with their existing market share. Without access to the financial records of individual retailers, it is not possible to know for certain why gasoline prices have remained static during 2012 and R. MARSHALL & ASSOCIATES i

3 A retailer s marketing margin is the price mark-up per liter that is applied to arrive at the retail price charged at the pump. A review of the averages for retailers across Canada indicates that a typical service station sells about 4.7 million liters per year and has a marketing margin of $0.08 per liter. Therefore, on average, a service station in Canada generates only about $376,000 per year from fuel sales to help cover the cost of operating the station and provide a profit. In 2010, the average pre-tax profit margin for service stations in Canada was only 5.3%, down from 10.3% in 2001 (stations considered to be chain stores enjoyed pre-tax profit margins of 7.1% in 2010 while independent service stations only had pre-tax profit margins of 1.8%). Clearly, the general profitability of service stations in Canada is not very good at present. Looking at NWT service station operators outside Yellowknife, the following observations were made: Most of the operators appear to be independents (not affiliated with a major oil company or refinery) which means they are in the same category of service stations that realized only 1.8% in pre-tax profit in 2010; and, The annual fuel sales volumes for these operators mostly range between 500,000 and 1,000,000 liters per year which is at least five times less than the national average of 4.7 million liters. If NWT service stations have much smaller local markets, it stands to reason they would need much higher marketing margins (in the range of $0.25 to $0.75 per liter) to cover their annual operating costs and make some profit, particularly in smaller communities where operating costs are very high. With regards to Yellowknife service stations, the following observations were made: The average fuel sales volumes range from less than 1.0 million to more than 5.0 million liter per year. The marketing margins have ranged from $0.24 to $0.48 per liter over the last 18 months with the average being $0.34. For the smaller service stations, an average margin of $0.34 / liter appears reasonable if their sales volumes are in the range of 1-2 million liters. If the larger retailers have similar sales volumes and annual operating costs as their southern counterparts, they may be enjoying very healthy profits. However, if their operating costs are considerably higher than southern operators, their profit levels are likely reasonable also. To try to get a sense of whether regulation would be worth the effort in terms of providing transparency in the setting of fuel prices, some of the implementation issues involved in establishing a fuel price regulatory system were explored. A number of questions, such as the method of regulation to employ, which fuel products to regulate, how frequently prices should be set and how monitoring and enforcement might work, all appear to have some challenges that would require a more detailed investigation particularly if regulation were to be applied only to Yellowknife service stations. Finally, some evidence from the experiences of other provinces with fuel price regulatory systems was examined. Some studies produced by academics or policy think tanks suggest that for various reasons, regulation may actually result in slightly higher prices for consumers while other studies indicate that, in the absence of regulation, service station operators in local markets may often engage in tacit price collusion whereby they generally follow the signal of the larger operators in either raising prices or not reducing them when costs decrease. Overall, the evidence is unclear on whether fuel price regulation actually contributes to a net gain in the broad public interest. Overall, the examination of NWT fuel retailers does not generally support the idea that fuel price regulation by the GNWT is needed to ensure consumers pay fair prices for gasoline and diesel fuel. To the extent that NWT consumers pay higher prices than elsewhere in Canada, this appears to be mostly the result of low annual sales levels (due to small markets) and high northern operating costs. R. MARSHALL & ASSOCIATES ii

4 NWT GAS PRICE REGULATION Preliminary Investigation September 2013 TABLE OF CONTENTS EXECUTIVE SUMMARY... I 1 INTRODUCTION Data Limitations and Methodology BACKGROUND Fuel Supplies in Canada Competition Bureau Fuel Price Regulation in Canada Fuel Markets in the NWT ANALYSIS Purpose and Objectives of Fuel Price Regulation Is There a Need for Fuel Price Regulation? Market Structure and Extent of Competition Fuel Price Fluctuations Marketing Margins and Service Station Profitability Implementing Retail Fuel Price Regulation in the NWT Pros and Cons of Fuel Price Regulation CONCLUSIONS AND RECOMMENDATIONS APPENDIX A: REFERENCES R. MARSHALL & ASSOCIATES iii

5 1 INTRODUCTION In recent months, some public concern has been expressed about the high cost of transportation fuel (gasoline and diesel fuel) in NWT communities and, in particular, the fact that gasoline prices in Yellowknife have remained virtually unchanged for months even though crude oil prices have fluctuated somewhat over time. In February 2013, a Motion (No. 6-17(4)) was passed in the NWT legislative Assembly requesting that the Government of the Northwest Territories (GNWT) investigate and evaluate the possibility of regulating gasoline prices as a means of potentially lowering the retail prices paid by consumers and ensuring fairness and transparency in petroleum product pricing. The idea of implementing GNWT fuel price regulation derives, in part, from the fact that there are five jurisdictions in Canada (the four Maritime provinces and Quebec) currently engaged in some form of fuel price regulation. The Department of Municipal and Community Affairs (MACA) hired R. Marshall and Associates to complete a preliminary investigation into these matters and provide a written report on the findings. 1.1 Data Limitations and Methodology Privately-owned fuel distributors and retailers in the NWT currently operate in a competitive market to sell gasoline and motive diesel fuel to NWT consumers. As private businesses, they are not required to submit financial information to the GNWT detailing their annual sales, operating expenses or profit margins. For taxation purposes, fuel distributors and retailers are required to provide sales volume statistics to the GNWT, however, this information is kept strictly confidential. As a result, the amount of information that is publically available on the operation of fuel distribution and retail businesses in the NWT is quite limited. This limitation prevents a direct determination of the fuel pricing practices and financial health of individual fuel retailers per se. On the positive side, there is an enormous amount of information available on the state of the oil and gas industry in Canada. Numerous organizations track and publish industry information and many studies have been undertaken over the years in response to public concerns about high fuel prices. The findings presented in this report were derived from a comparative analysis of information compiled from other Canadian jurisdictions and from various GNWT sources. The conclusions drawn have been based on the evidence available and could be subject to revision if additional NWT-specific information is obtained at a future date. R. MARSHALL & ASSOCIATES 1

6 2 BACKGROUND From 1974 to 1985, federal legislation and agreements with the oil-producing provinces placed crude oil prices under government regulation. The regulation involved a complex system of oil export controls, export taxes and oil import subsidies for Canadian refineries. Due to concerns about disincentives for business investment in new crude oil supplies and efficient energy use by consumers, the governments of Canada, Alberta, Saskatchewan and British Columbia agreed (through the 1985 Western Accord) to remove crude oil price controls. Canada is now committed to a market-based approach to oil and fuel prices which means that competitive market forces determine prices. With the exception of a national emergency, the Government of Canada has no jurisdiction over the direct regulation of retail fuel prices. Under the Canadian Constitution, the provinces (and territories) have the authority to regulate fuel prices. Some provinces choose not to exercise this authority while others (Prince Edward Island, Newfoundland and Labrador, Nova Scotia, New Brunswick and Quebec) do regulate fuel prices in some way. 2.1 Fuel Supplies in Canada As a starting point, it is helpful to review how crude oil and fuel markets are organized in Canada 1 : Crude Oil Markets Oil is produced in numerous regions of the world and is bought and sold in relation to global prices. Due to the fact that there are many varieties and grades of oil, several benchmark types of crude oil are quoted. Other varieties of oil are priced at a discount or premium to the benchmark, depending on their quality. For example, West Texas Intermediate (WTI) is a light, sweet (low sulphur) crude oil that is used as a benchmark in North America. Light sweet crude oils sell at higher prices than heavy, sour (high sulphur) crude oils (which are more difficult and costly to refine and yield less of the valuable refined products such as gasoline or jet fuel). Canada holds the second largest oil reserves in the world (~178 billion barrels) and is a net exporter of both crude oil and refined petroleum products. The two major oil producing regions are the Western Canada Sedimentary Basin and offshore eastern Canada. Modest volumes of oil are also produced in Ontario and the NWT. Oil Refineries Oil refineries are the primary consumers of crude oil. A refinery is a complex manufacturing facility that uses chemistry to break, reshape and recombine the molecules of crude oil into value-added products such as gasoline, diesel, aviation fuel and heating oil. Currently, there are nineteen (19) operating refineries in Canada. In the 1970s, there were more than forty, however, many of the smaller, inefficient refineries have closed in favour of larger, cleaner and more efficient refineries. In capacity terms, Canada now has double the refining capacity than it did in the 1970s, even though the number of refineries has decreased. 1 The information presented in this section is based on factsheets and other information obtained online from Natural Resources Canada ( the Canadian Fuels Association ( and the National Energy Board ( R. MARSHALL & ASSOCIATES 2

7 In Western Canada, there are eight operating refineries; two in British Columbia, three in Alberta and three in Saskatchewan. In total, these eight refineries have the capacity to produce about 100,000 cubic metres of refined product per day, which represents about 30% of Canada s total refining capacity. The Western Canadian refineries only process Canadian crude oil. Fuel Distribution Generally, products such as gasoline and diesel are produced and blended at the refinery and shipped to retail locations using a complex distribution network of pipelines, ships, railways, storage terminals and trucks. Fuel distribution is organized into three regional networks (Western Canada, Ontario and Quebec/Atlantic Canada) which generally operate independently of each other. Refineries in Western Canada supply all product demand from Vancouver to Thunder Bay, including the northern territories. As the distance from the refinery to the consumer point-of-sale increases, the cost per unit of product generally increases due to transportation costs. Fuel Retailing The 2012 national retail petroleum site census (published by MJ Ervin & Associates) determined that there were about 12,285 retail gasoline stations operating in Canada. This is significantly less than the more than 20,000 stations that were in operation in 1989 and reflects an ongoing shift in retail gasoline ownership from refiners to non-refiners and a trend towards the big-box gasoline retailer which sells fuel and other products and services to meet consumer demands for one-stop shopping. Of these, only 23% of the service stations in Canada are under the price control of either the three major oil companies (Shell, Esso and Suncor (Petro Canada) that have fully integrated operations in production, refining and retail) or the nine integrated refiner-marketers (i.e. involved in refining and retail) that operate in Canada. The remaining 77% of the stations are operated by independent chains or owner-operators that are not involved in the refining sector. These operators are strictly price-takers when purchasing fuel supplies. While there are now fewer retail stations, they tend to be larger operations with higher average fuel sales volumes and additional services such as a convenience store or car wash. 2.2 Competition Bureau The Competition Bureau is an independent law enforcement agency responsible for the administration and enforcement of the Competition Act. Its role is to promote and maintain fair competition so that Canadians can benefit from competitive prices, product choices and quality services. The Competition Act is a federal law governing most business conduct in Canada. It contains both criminal and civil provisions aimed at preventing anti-competitive practices in the marketplace. It is important to note that the Competition Act does not provide the Bureau with the power to regulate retail fuel prices this authority resides with provincial and territorial governments. Significant areas of activity for the Competition Bureau include investigations of cartels and preventing abuse of market power by firms that dominate a particular market. R. MARSHALL & ASSOCIATES 3

8 A cartel is defined as a formal or informal group of otherwise independent businesses who work together to lessen or prevent competition among its participants. Typical cartel activities may include price-fixing, market allocations, limiting of production or supply or rigging bids. These practices are considered harmful as they typically result in higher prices for consumers and reduce the incentives for companies to cut costs and be innovative. In many industries, firms very often need to become large (in relation to their market) in order to reduce production costs or to compete with other firms. Examples include automobile manufacturing, airlines, financial services (banking, insurance) and utilities (telecom, natural gas, electricity). However, if a firm exploits its market power in a way that hurts competition in the marketplace, this may be contrary to the Competition Act. Typical examples of market power abuses include buying up a competitor s supplies or customers, placing conditions on the supply of a product, refusing to supply product or price maintenance (i.e. preventing a customer from re-selling a product below a minimum price). Since 1986, the Competition Bureau has been involved in numerous activities relating to gasoline and other petroleum products. This activity has included prosecutions, merger reviews, interventions before regulatory boards, gasoline pricing inquiries and the commissioning of independent studies. While these efforts have uncovered some instances of anti-competitive practices, it should also be noted that various investigations of gasoline pricing over the years have found that changes are often due to market forces, not inappropriate behaviour on the part of the industry. 2.3 Fuel Price Regulation in Canada The different fuel price regulatory systems that exist in Canada are summarized below: New Brunswick 2 New Brunswick began to regulate the maximum price of certain petroleum products in 2006 (pursuant to the Petroleum Products Pricing Act and Regulation ). The stated purpose of regulation is to reduce the daily volatility in retail petroleum prices while ensuring that consumers pay the lowest possible price without jeopardizing the supply of products. The products regulated include gasoline, diesel fuel, furnace oil, and propane. The New Brunswick Energy and Utilities Board is responsible for administering this system which makes use of a formula to determine the maximum prices for regulated products. The maximum prices are normally published every Thursday morning but, on occasion, may be published on other days if very large market changes occur. Retailers are not required to sell at the maximum regulated price and can compete at lower prices if they choose. The formula used to set the maximum prices involves the use of benchmark prices (from the New York Mercantile Exchange) and the addition of wholesale and retail margins as well as applicable federal and provincial taxes. In the event of an abnormal spike up or down in rack prices, the Board can use an interrupter clause to re-set the maximum retail prices without having to wait until the following week. Since 2007, when the current version of the interrupter clause came into effect, it has only been used a total of four times. 2 This summary is based on information obtained online from the New Brunswick Department of Energy and Mines and the New Brunswick Energy and Utilities Board. R. MARSHALL & ASSOCIATES 4

9 Nova Scotia 3 Prior to 2009, the Minister of Service Nova Scotia and Municipal Relations was responsible for setting the prices of petroleum products. Since October 2009, the Nova Scotia Utility and Review Board (the Board) has been responsible for prescribing wholesale and minimum and maximum retail prices for all grades of gasoline and low-sulfur diesel fuel. The Board s authority derives from the Petroleum Products Pricing Act and the Petroleum Products Pricing Regulations. The stated purpose of regulating petroleum product pricing is to ensure just and reasonable prices for specified products taking into consideration the objectives of preserving the availability of such products in rural areas, stabilizing prices for such products and minimizing the variances in prices of such products across the province. The Board follows a similar process as New Brunswick by first determining a benchmark price based on commodity pricing on the New York Mercantile Exchange. The fixed wholesale rate is then calculated by adding a wholesale margin, applicable taxes, a transportation allowance, a forward averaging correction and when appropriate, a winter blending allowance (for diesel only). The wholesale price and the minimum and maximum self-service pump prices and the minimum full-service pump price are published on a weekly basis. The Board does not set a maximum retail price for full-service pumps. The Board can also make use of an interrupter clause to respond to sudden and significant spikes up or down in petroleum prices. The Interrupter is considered for use when the market price for a product fluctuates by a range of +/- 6 to 8 cents per liter compared to the weekly benchmark price set by the Board and the change is sustained. Prince Edward Island 4 The Prince Edward Island Regulatory and Appeals Commission is responsible for setting petroleum product pricing under the authority of the Petroleum Products Act. The Commission s role is to ensure at all times a just and reasonable price for heating fuel and motor fuel to consumers and licensees within the province. The Commission normally adjusts prices on the 1 st and 15 th of each month based on the average changes in market prices for refined products traded on the New York Mercantile Exchange over a two-week period. Other factors such as international, national and regional market conditions may also be taken into account by the Commission in its determination of pricing. A minimum and maximum price range is set for retail gasoline and diesel products whereas only maximum prices are set for furnace oil, stove oil and propane. Newfoundland and Labrador 5 Fuel pricing regulation has been in effect in Newfoundland and Labrador since In 2004, this responsibility was given to the Board of Commissioners of Public Utilities. The Board s mandate is to is to set the maximum price at which all types of motor fuels (gasoline and diesel) and heating fuels (furnace oil, stove oil and propane) may be sold. 3 This summary is based on information obtained online from the Nova Scotia Utility and Review Board. 4 This summary is based on information obtained online from the Island Regulatory and Appeals Commission. 5 This summary is based on information obtained online from the Newfoundland and Labrador Board of Commissioners of Public Utilities. R. MARSHALL & ASSOCIATES 5

10 The maximum prices for the regulated products are set every Thursday (at 12:01 am) and are based on the average market prices for these commodities on the New York Mercantile Exchange for the preceding seven-day period (up to the Tuesday of that week). Suppliers and retailers may sell product to consumers for less than the maximum prices but may not exceed them. The Board also has the power to make intervention adjustments to the maximum prices in extraordinary circumstances in response to significant volatility in commodity market pricing. Quebec The Regie de L Energie du Quebec is responsible for monitoring the price of petroleum products in the province and for publishing a weekly estimate of the cost to the retailer to sell gasoline and diesel fuel. Under its mandate for monitoring petroleum prices, the Regie collects, compiles and disseminates retail pump prices for gasoline and diesel fuel. During the heating season, it also monitors the retail price of heating oil. Each week, the Regie also publishes an estimate of the cost to retail stations to sell gasoline and diesel fuel. These estimated minimum prices (EMP) are determined for three types of fuel in each of the 17 administrative regions and 120 municipalities in Quebec. The calculation of the weekly EMP is based on the minimum price from the Montreal loading ramp (rack price) plus taxes, minimum transportation costs and the Regie s allowance for the estimated cost of operating a service station. The estimated cost, in cents per liter, to operate a retail service station is determined by the Regie every three years. 2.4 Fuel Markets in the NWT 6 Transportation fuel, such as gasoline, diesel fuel and aviation fuels, represents about 30% of the annual energy use in the NWT. In 2011/12, about 215 million litres of product was imported for transportation uses. The NWT s annual supplies of transportation fuels are imported from Edmonton refineries via railcar to Hay River and via tanker trucks directly to communities on the all-weather highway system. Communities along the Mackenzie River receive annual fuel re-supply from storage terminals in Hay River via summer barge. Communities not accessible by barge are re-supplied via winter roads from regional storage facilities. The responsibility for providing transportation (and other) fuels in NWT communities is shared between the GNWT s Petroleum Products Division (PPD) and various private sector wholesale and retail operators. PPD provides petroleum products in sixteen (16) communities that are not served by the private sector. PPD serves a total population of about 4,575 people and sells about 3.4 million liters of gasoline and 1.9 million liters of motive diesel fuel to NWT consumers (about 5.3 million liters in total). 6 The information in this section has been compiled from several sources including PWS Petroleum Products Division, ITI s Energy Planning Division and the Arctic Energy Alliance. R. MARSHALL & ASSOCIATES 6

11 All other NWT communities are served by private sector fuel wholesalers and retailers (via an estimated 37 service stations). Data on fuel sales volumes for individual retailers are not publically available. Various information sources from the GNWT and the Arctic Energy Alliance were used to compile an estimate of the regional breakdown of total annual sales of gasoline and motive diesel fuel in NWT communities (i.e. by the private sector and PPD combined, as shown in Table 1 below): Table 1: Estimated Total NWT Gasoline and Motive Diesel Fuel Markets By Region Region Population (2012) Re-Supply Methods 1 Annual Sales (liters) Gasoline 2 Diesel Total Beaufort-Delta 6,775 AWR / Barge 6,757,288 2,016,385 8,773,673 Sahtu 2,680 Barge / WR 2,927,780 1,005,830 3,933,610 Dehcho 3,345 AWR / WR 4,754,850 2,778,885 7,533,735 South Slave 7,010 AWR / Barge 8, ,377,665 10,444,090 Tlicho 3,155 AWR / WR 2,635, ,715 3,463,855 YK Area 20,010 AWR 18,000,000 5,000,000 23,000,000 Total 42,975 43,141,483 14,007,480 57,148,963 Notes: 1: AWR = all weather road, WR = winter road 2: Includes on-road and off-road uses of gasoline The figures below summarize the breakdown in annual gasoline and diesel fuel sales between PPD and the private sector operators: Operator Gasoline Sales Diesel Fuel Sales Annual Total PPD 3.3 million liters 1.5 million liters 4.8 million liters Private Sector 39.8 million liters 12.5 million liters 52.3 million liters 43.1 million liters 14.0 million liters 57.1 million liters For the purposes of this study, it is assumed that the annual volume of transportation fuel that could be subject to GNWT price regulation is about 52.5 million liters 40 million liters 7 of gasoline and 12.5 million liters of diesel. 7 This estimate for annual gasoline sales in non-ppd communities corresponds closely to Statistics Canada data (from Table ) which indicates that million liters of gasoline was consumed on public roads in the NWT in R. MARSHALL & ASSOCIATES 7

12 Table 2 below provides additional information on the gasoline and motive diesel fuel markets in the fifteen communities (Yellowknife includes N Dilo and Dettah) served by the private sector: Table 2: Gasoline & Motive Diesel Fuel Markets in Communities Served by Private Sector Community Pop. (2012) # of Privately- Owned Stations Estimated Total Sales of Gasoline and Motive Diesel (liters / year) Estimated Average Sales Per Station (liters / year) Re-Supply Method Aklavik , ,320 Barge / AWR Ft. McPherson ,495, ,715 AWR Inuvik 3, ,111,000 1,277,750 Barge Tuktoyaktuk , ,000 Barge / WR Norman Wells ,680, ,000 Barge Ft. Liard , ,550 AWR Ft. Providence , ,950 AWR Ft. Simpson 1, ,567,855 1,141,964 AWR H. R. Reserve , ,935 AWR Enterprise , ,000 AWR Ft. Resolution , ,855 AWR Ft. Smith 2, ,461, ,250 AWR Hay River 3, ,720,000 1,430,000 AWR Behchoko 2, ,908,285 1,454,140 AWR Yellowknife 1 20, ,000,000 3,833,000 AWR Total 2 38, ,705,180 1,464,000 Note: 1. Includes N Dilo and Dettah 2. Kakisa not included due to lack of data R. MARSHALL & ASSOCIATES 8

13 3 ANALYSIS This section of the report attempts to determine whether there is sufficient evidence to support the idea that fuel prices should be regulated, how such regulation might be implemented and what the pros and cons may be for fuel retailers and consumers. 3.1 Purpose and Objectives of Fuel Price Regulation In economic theory, regulation is defined as government imposition of controls or provision of incentives for the purposes of directing, restricting or changing the economic behaviour of businesses and individuals 8. The general purpose of regulation is to protect businesses and consumers from market failures and safeguard social and environmental values. Regulation is distinguishable from other instruments of government policy in that: Regulation affects choices of producers, distributors and consumers. Choices normally determined by free market forces are influenced or modified through an administrative process; The imposition of rules is supported by penalties. Regulation is coercive in nature, where rules are enforced under the threat of penalties for non-compliance; and, Rules are often administered by a commission or agency with authority based in statute. In the process of interpreting and applying the provisions of the statute, the agency may establish more detailed regulations which may be considered a form of subordinate legislation. A review of the retail fuel price regulatory systems in place in Quebec, Prince Edward Island, New Brunswick, Newfoundland and Labrador and Nova Scotia indicates that there are several potential public policy objectives, or reasons, for regulating retail fuel prices. These include: 1 Reducing the daily volatility in retail petroleum prices and/or to minimize the variances in prices of such products across the province (territory); 2 Ensuring that consumers pay just and reasonable prices (or alternatively the lowest possible prices) while ensuring the availability of supply throughout the province (territory); 3 Promoting fairness and transparency in how retail fuel prices are set; and, 4 Protecting small retailers from being squeezed out of the marketplace by larger retailers engaging in predatory pricing (i.e. setting retail prices close to, or below, costs to increase market share or eliminate competitors). The general applicability of each objective to the NWT s retail fuel markets is discussed below. 8 Federally regulated industries (or sectors) include financial services (banking & insurance), telecommunications, transportation (air, marine, road and rail), environment, food and agriculture, health, and natural resources (nuclear energy, pipelines, mines, fisheries, forestry). Areas of provincial regulatory authority include oil and natural gas, pipelines, electricity, securities, employment standards, labour relations etc.) R. MARSHALL & ASSOCIATES 9

14 With respect to Objective #1, there are eleven (11) communities connected to the all-weather highway system and of these, ten (10) are served by private sector retailers that receive fuel deliveries throughout the year (see Table 2 above). There does not seem to be much public concern with fuel price volatility, in fact, the concern expressed about Yellowknife gasoline prices involved a lack of movement in gas prices (see section 3.2 below). Fuel price volatility isn t an issue in communities that receive annual fuel supplies by summer barge or winter road delivery as retail fuel prices tend to be fixed for extended periods of time up to one year. The other public policy consideration present in Objective 1 is the concept of reducing the variance in retail fuel prices between communities. Given the numerous differences that exist in the size of NWT communities, their distance from southern fuel wholesalers and the different delivery methods (rail, barge, truck) used to supply fuel to communities, any attempt to levelize or average retail fuel prices across communities would require significant crosssubsidization from low-cost communities to high-cost communities. As evidenced by other public policy discussion of this nature (i.e. electric power rates), introducing cross-subsidization tends to be quite controversial and politically divisive. With respect to Objective #4, the concern about smaller retailers being squeezed out of business by larger retailers engaged in predatory pricing does not seem to be a matter for concern in the NWT. If anything, the concerns being expressed about persistently high fuel prices locally, even when fuel prices have dropped elsewhere in Canada, suggests that there may not be that much competition between the fuel retailers operating in a community. This would tend to favour smaller retailers who may not otherwise have the financial strength to participate in local price wars to preserve their market share. Objectives #2 and #3, which involve the balancing of the interests of the retailers and consumers and the setting of prices in a fair and transparent manner, are similar to the concerns raised in Motion 6-17(4). For the purposes of this analysis, it is presumed that the specific public policy objectives for regulating retail fuel prices in NWT communities served by the private sector would be to: Ensure that consumers pay just and reasonable prices (or alternatively the lowest possible prices) while ensuring the availability of supply throughout the territory; and, Promote fairness and transparency in how retail fuel prices are set. The evidence for whether these two public policy objectives should be pursued in the NWT is presented in section Is There a Need for Fuel Price Regulation? There are three different market characteristics that can be examined to try to determine whether fuel price regulation may be warranted in the NWT. These include: the market structure and extent of competition that exists in the communities served by private sector retailers; the recent history on fuel price fluctuations; and, the fuel retailers marketing margins and profitability. R. MARSHALL & ASSOCIATES 10

15 3.2.1 Market Structure and Extent of Competition In economic theory, a competitive market is defined as one in which a large number of producers compete with each other to satisfy the demands of a large number of consumers. No single producer (or group of producers) and no single consumer (or group of consumers) can dictate how the market operates or determine the price or how much will be exchanged. Some conditions are necessary for a competitive market to form. These include: No barriers to entry or exit. Firms can enter the market if it is profitable to do so or exit if they are not profitable. This ensures that the supply of goods in the market can adjust to the level of demand from consumers; Profit maximization. Firms are assumed to sell at prices that maximize their profits; and, Homogeneous products. The qualities and characteristics of the products sold are identical (or very similar) between suppliers. Consumers therefore make purchasing decisions based solely on price and tend not to display loyalty to any particular supplier. Applying these criteria to the NWT retail fuel market, it is clear that the retailers are selling identical products (gasoline and diesel) and must be price-competitive to attract consumers. This is particularly so as the prices of gasoline and diesel are prominently displayed on large signs that consumers can easily see when driving by. These are the conditions that can cause price wars in some urban markets where fuel prices can fluctuate quickly, sometimes in a matter of hours or days, as retailers compete for customers, sometimes even to the point of selling below costs. In theory, a competitive market is the preferred choice as it generally leads to an appropriate allocation of society s resources. In other words, the market has an appropriate number of suppliers relative to demand, prices can adjust as needed to balance supply and demand and consumers have their choice of suppliers and access to the lowest prices. Regulation is typically considered a second-best alternative to competition that is introduced in order to protect businesses and consumers from a failure in the market. In the context of NWT retail fuel markets, the market failure that regulation would potentially address is either an insufficient degree of competition among fuel retailers (i.e. in communities with only one supplier) or a lack of competitive intensity among the retailers (i.e. in communities with several retailers but where prices appear to remain constant even as market conditions change). Table 2 above provides a summary of the fifteen (15) communities served by private sector retailers. Some observations that can be drawn from this information are as follows: There are an estimated 37 privately-owned service stations in non-ppd communities or within a reasonable distance of a community; Of these, only four communities (Aklavik, Fort Liard, Hay River Reserve and Fort Resolution) are served by a single operator. The other ten communities are served by two or more fuel retailers which suggests some level of local competition; Judging by the branding (i.e. names) of the various service stations, only a few carry the names of the major oil companies in Canada (Esso, PetroCanada, Shell). Most are independent operators that are strictly price-takers in purchasing wholesale fuel supplies i.e. have no ability to purchase fuel at discounted or favourable pricing; and, R. MARSHALL & ASSOCIATES 11

16 Only the service stations in larger communities (Inuvik, Fort Simpson, Hay River, Behchoko, Yellowknife) are averaging total sales of more than 1.0 million liters per year. Many operators appear to be selling between 500,000 to 1,000,000 liters per year which is very low compared to typical service stations in Canada. In conclusion, most operators face some degree of local competition even though the size of the fuel retailing market in their community is quite small. With low annual throughput, these stations are not likely to be very profitable as much of the operating expense of running a service station is fixed (i.e. lease costs, utilities, overhead, wages etc.) and doesn t vary with sales. Given the small size of these local markets, the presence of competition in many of the communities and the poor economics typically associated with small, independent service stations, there does not appear to be a compelling case for fuel price regulation based on these observations Fuel Price Fluctuations Table 3 provides a snapshot of the price of regular unleaded gasoline and the marketing margin available to retailers in Yellowknife 9, Whitehorse and the rest of Canada for the last eighteen (18) months. Table 3: Monthly Retail Prices and Marketing Margins - $ per liter Yellowknife Whitehorse Rest of Canada Month Price 1 Marketing Price Marketing Margin 2 Margin Price 3 Marketing Margin Jan 2012 $1.39 $0.41 $1.26 $0.28 $1.23 $0.08 Feb 2012 $1.39 $0.37 $1.26 $0.23 $1.27 $0.07 Mar 2012 $1.39 $0.32 $1.32 $0.21 $1.31 $0.08 Apr 2012 $1.39 $0.31 $1.36 $0.26 $1.35 $0.09 May 2012 $1.39 $0.34 $1.37 $0.24 $1.30 $0.10 Jun 2012 $1.39 $0.32 $1.36 $0.26 $1.26 $0.10 Jul 2012 $1.39 $0.34 $1.36 $0.31 $1.27 $0.09 Aug 2012 $1.39 $0.30 $1.36 $0.31 $1.30 $0.08 Sep 2012 $1.39 $0.28 $1.36 $0.34 $1.32 $0.08 Oct 2012 $1.39 $0.34 $1.36 $0.33 $1.29 $ Yellowknife is the only NWT community for which monthly pricing statistics could be located. R. MARSHALL & ASSOCIATES 12

17 Nov 2012 $1.39 $0.41 $1.35 $0.38 $1.22 $0.08 Dec 2012 $1.39 $0.45 $1.31 $0.36 $1.19 $0.08 Jan 2013 $1.39 $0.48 $1.30 $0.33 $1.20 $0.07 Feb 2013 $1.39 $0.36 $1.28 $0.20 $1.30 $0.07 Mar 2013 $1.39 $0.33 $1.29 $0.21 $1.30 $0.08 Apr 2013 $1.39 $0.36 $1.28 $0.25 $1.26 $0.09 May 2013 $1.39 $0.24 $1.33 $0.22 $1.30 $0.07 Jun 2013 $1.39 $0.24 $1.48 $0.38 $1.32 $0.09 Average $1.39 $0.34 $1.33 $0.28 $1.28 $0.08 Notes: 1. Prices shown are for regular unleaded gasoline at self-serve stations 2. Margin data were taken from MJ Earvin & Associates monthly reports 3. Average prices for Canada derived from Natural Resources Canada s website Table 3 confirms that the price of regular unleaded gasoline in Yellowknife has remained virtually unchanged at $1.39 per liter over the last eighteen (18) months (small changes in price over a few days may be masked by monthly averages). By contrast, the price of gasoline ranged from $1.26 to $1.48 per litre in Whitehorse and from $1.19 to $1.35 per liter across the rest of Canada. It is hard to discern whether consumers are better off in a market like Whitehorse compared to Yellowknife. Both territories purchase fuel from Western Canadian refiners and therefore experience the same underlying costs for crude oil and refinery margins. The differences in price are most likely due to the timing of re-supply purchases, transportation cost differences and the degree of competition in local markets. During most of this period, Whitehorse gas prices were slightly cheaper than in Yellowknife. However, it is interesting to note that gas prices in Whitehorse appear to be lower during winter and more expensive during summer. There may be cost differences that account for this or alternatively, retailers in Whitehorse may be adjusting prices upwards during tourist season (the June 2013 price of gas in Whitehorse was $1.48). Overall, it is curious that Yellowknife gasoline prices have remained static over an 18 month period while prices varied by about 15 cents per liter in other parts of Canada. From an economics perspective, this suggests two possibilities: that the fuel retailers in Yellowknife are generally making modest profits but are not sufficiently profitable to be tempted to compete with each other for a greater market share by engaging in price wars. In this type of local market, the profits of each operator are maximized by maintaining their own market share at reasonable operating margins; or, R. MARSHALL & ASSOCIATES 13

18 that Yellowknife fuel retailers are generally making exceptional profits by charging artificially high prices. But, if this was the case in Yellowknife, one would expect new operators to eventually enter the market and compete for market share by offering lower prices. In fact, in recent years, the number of service stations in operation appears to have decreased as the closure of the Yellowknife Motors service station did not result (to the author s knowledge) in the opening of any new service stations. In the absence of actual data on the financial performance of the fuel retailers in Yellowknife, it is not possible to know for certain why gasoline prices have remained unchanged during 2012 and In conclusion, gasoline prices in Yellowknife have been static for at least 18 months but there is no clear evidence that these operators are enjoying undue levels of profit as a result. With respect to the other NWT communities, no conclusion is possible as there are no data available to examine regarding monthly price changes or retailers financial health. The question of service station operating margins and profitability is examined below Marketing Margins and Service Station Profitability The marketing margin is the price mark-up per liter of fuel that is applied by the fuel retailer to arrive at the retail price charged at the pump. It is the marketing margin multiplied by the amount of fuel sold that determines the revenue available to the operator to cover costs and generate a profit. Canadian Context Before looking at the NWT, it is helpful to review the average marketing margin and general level of profitability of retail fuel outlets in Canada. As shown in Table 2 above, the average marketing margin in Canada for a service station in Canada is currently about $0.08 per liter. In 2012, the total amount of regular unleaded gasoline and motive diesel fuel sold by the 12,285 service stations was approximately 57.8 billion liters (40.4 billion liters of gasoline and 17.4 billion liters of diesel). Dividing the total amount of fuel sold by the number of service stations indicates that the average station sold about 4.7 million liters. Multiplying this annual sales throughput by the $0.08 margin indicates that the average service station in Canada generates only about $376,000 per year from fuel sales to help cover operating costs and provide a profit. Three sources of information were located to obtain a general understanding of typical service station profitability in Canada. The first is a publication from Industry Canada that examines the operating revenue and expenses of retail gasoline stations. In 2010, the average pre-tax profit margin for service stations was only 5.3%, down from 10.3% in Breaking this down further, stations considered to be chain stores enjoyed pre-tax profit margins of 7.1% in 2010 (15.8% in 2001) while independent service stations only had pre-tax profit margins of 1.8% (2.3% in 2001). Clearly, the general profitability of service stations in Canada is not very good and is about half of what it was in Another source of information is a study completed in 2006 for the Competition Bureau of Canada (see LECG Canada, 2006). This study examined the operations and profitability of four service stations in Canada during the period 2002 to A key finding was the fact that all four stations made little or no profit on fuel sales and relied very heavily on ancillary services (i.e. carwash, fast food sales, convenience store etc.) to actually cover all operating expenses and provide some profit. R. MARSHALL & ASSOCIATES 14

19 A final source of information is available in the 2012 National Retail Petroleum Site Census (see MJ Earvin & Associates, 2013). The Executive Summary contains the following relevant points: As of December 31, 2012, there were 12,285 retail gasoline stations operating in Canada; 3.5 outlets for every 10,000 persons. The per capita number of outlets varies significantly from one province to another; and this has a strong relationship to throughput efficiency by province, which in turn has significant implications for the level of retail markup in each province s markets. Markets with poor (low) throughput efficiencies tend to have higher retail gasoline prices (after tax differences are factored out) than those with high throughput efficiencies. The provision of goods or services other than gasoline is of vital importance to the competitiveness and viability of retail gasoline outlets, since (based on other research) the gross margin on gasoline itself is generally not sufficient to provide for the operating costs and reasonable return on the operation of these facilities. NWT Margins and Profitability Using the national service station information as a guide, it is possible to make an educated guess about how service stations in the NWT are doing in terms of pricing and profitability. With regards to fuel retailers in communities outside Yellowknife, the following observations can be drawn (based on the research completed for this study): The branding of the various service stations in the NWT indicates most are independently owned or operated (i.e. not affiliated with major oil refiners or fuel distributors). This puts most of these operators in the independents category of service stations which, elsewhere in Canada, realized averaged pre-tax profit margins of only 1.8% in 2010; and, The annual sales volumes for these operators range from about 0.5 to 1.5 million liters of product. This is much less annual throughput compared to the national average of about 4.6 million liters per service station in If NWT operators have much smaller local markets, it stands to reason that they would need to have a much higher marketing margin per liter of product sold (in the range of $0.25 to $0.75 per liter) to be able to cover their annual operating costs and make some profit, particularly in small communities which have very high operating costs. With regards to Yellowknife service stations, the following observations can be drawn: The annual fuel volumes sold in Yellowknife service stations range from less than 1.0 million to more than 5.0 million. The larger operators appear to have annual sales volumes similar to average service stations elsewhere in Canada; The marketing margins, as shown in Table 3 above, have ranged from a low of $0.24 to a high of $0.48 per liter over the last 18 month period with the average being $0.34 / liter. This is about 4 times higher than the national average margin of $0.08 / liter. For the smaller retailers, this would appear reasonable if their annual sales are in the range of 1-2 million liters (the costs to operate a service station are mostly fixed and do not decline significantly with lower fuel sales). If the larger retailers have annual operating costs similar to southern operators, then they may be enjoying very healthy profits. However, if their operating costs are considerably higher than their southern R. MARSHALL & ASSOCIATES 15

20 counterparts (which would be expected), it would appear that they are reasonably profitable but not outrageously so. In conclusion, the information presented in this section tends to suggest that the majority of the NWT fuel retailers are not charging artificially inflated prices for gasoline and diesel fuel and, if similar to southern gas stations, may only be breaking even or making very modest profits on fuel sales. Overall, the conclusions presented in this section do not support the idea that fuel price regulation by the GNWT is needed to ensure consumers pay just and reasonable prices for fuel. To the extent that NWT consumers pay more for gasoline and diesel fuel than southern consumers, this appears to be the result of low annual sales levels (due to small markets) and high northern operating costs. 3.3 Implementing Retail Fuel Price Regulation in the NWT The second public policy objective that could potentially be served through regulatory oversight is the idea of promoting fairness and transparency in the setting of fuel prices. It isn t really possible to quantify the potential benefits to the motoring public of fairness and transparency of fuel prices other than to acknowledge that consumers would presumably feel reassured that the prices they pay at the pump have been reviewed and are reasonable in relation to the retailer s costs to provide the product. 10 What can be examined in some detail is the system of regulatory oversight the GNWT would need to create to ensure gasoline and diesel fuel prices are fair and set in a transparent manner. It is beyond the scope of this study to design, in detail, a system for GNWT regulation of fuel prices, however, the issues described below are key aspects that would need to be addressed if such a system were to be considered: Agency The other Canadian jurisdictions that are involved in fuel price regulation have tasked an existing regulatory agency with the responsibility of administering the system. This has some obvious advantages including efficiency (not creating a separate agency), availability of expertise (technical staff) and independence (politicians aren t responsible for setting the prices). In the NWT, the Public Utilities Board (which already regulates natural gas distribution and electricity providers) would appear to be the logical choice if fuel price regulation were introduced. At present, the Board is headquartered in Hay River and has one full-time staff member and a full-time Chairperson. All other Board members serve in a part-time capacity. Technical and legal capacity to support the Board is obtained, as needed, from outside contractors. Method and Scope of Regulation If a system to regulate retail fuel prices is introduced, there are a number of issues that would need to be considered in the design and application of the regulatory system. 10 In the context of the high cost of living in NWT communities, it should also be noted that notions of fairness and transparency may not necessarily address public concerns about affordability. These are separate issues. R. MARSHALL & ASSOCIATES 16