REGULATION OF THE GAS SUPPLY MARKET FREQUENTLY ASKED QUESTIONS

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1 REGULATION OF THE GAS SUPPLY MARKET FREQUENTLY ASKED QUESTIONS Why is it necessary to regulate gas supply in a free market? Manx Gas has a natural monopoly in the Isle of Man gas supply market. Given the small scale and high cost of entering the market, it is unlikely in the extreme that another company would try and compete. Consumers have been concerned that the monopoly position could be exploited. By regulating Manx Gas, the OFT can work to ensure that the market operates in a way that is both fair and sustainable in the long term. Does the agreement actually prevent competition? No; and section 2 of the Gas and Electricity Act 2003 specifically allows for competition in the gas supply market. Having said that, the OFT believes that there is no real prospect of actual competition, so has negotiated this regulatory agreement. What is voluntary regulation? The OFT, Treasury and Department of Economic Development have negotiated with Manx Gas and signed a contract providing a regulatory framework for gas supply. That contract is now binding on all parties for at least 4 years. It is voluntary only to the extent that all the parties chose to enter into the agreement; in other words, it has not been imposed through the introduction of legislation. Once signed it became a legally binding contract. What is the benefit to Manx Gas of entering into this agreement? Manx Gas receives a stable return each year and therefore the business is substantially derisked. Whilst the profitability of the company is reduced fairly substantially, the reassurance that it will earn the return provides the benefit. Page 1

2 Why did the OFT not impose statutory regulation? In 2011 the Department of Economic Development and OFT commissioned a report from specialists in regulatory economics, which recommended what it concluded to be the best method of regulation for the Isle of Man gas market. This report confirmed that the cost to Government of statutory regulation was likely to be around 250,000 per annum. Provided that voluntary regulation works, it is a much more cost effective way of achieving the same end. Not only does it cost the taxpayer much less, but it also imposes less of a cost on Manx Gas; cost which ultimately would be passed on to the consumer. What happens if Manx Gas breaches the agreement? Having freely entered into the agreement, Manx Gas would be unlikely to breach it. If, however, the company does so, it would be in breach of contract. Clause 15 of the agreement allows for termination following a material breach. If the agreement is breached, the OFT would seek approval to introduce legislation to formally regulate gas supply. Does the agreement prevent any future investigations by the OFT into the gas market? One of the obligations of the OFT under the agreement is that it will not carry out any price investigations under Section 19 of the Fair Trading Act 1996 during the term of the agreement. However, investigations into anti-competitive practices under the Fair Trading Act 1996 could be pursued, if necessary. How is the agreement regulating the gas supply market? The 2008 further investigation into gas prices (under section 19A of Fair Trading Act 1996) set out to determine whether Manx Gas was charging excessive prices. It was first required to decide upon a benchmark of what constitutes a competitive price. The report determined that assessing profit levels would be a good comparator, since if profits were excessive, then prices must also be. The investigation concluded that, over the period reviewed, Manx Gas was not making excessive profits. The most appropriate way of measuring profitability in an industry requiring a high level of capital investment, such as gas supply, is the relationship between profits and the capital cost of the assets used to produce those profits. This concept (which is referred to by accountants and economists as Return on Capital Employed or ROCE) is widely used by utilities regulators. It is emphasised that ROCE is a measure of profitability; it is not the profit margin. The 2008 report not only defined the acceptable range of ROCE in 2008, it also set out a formula to recalculate it in the future. The 2015 agreement is based on a re-valuation of the formula. The agreement fixes the profitability of Manx Gas at a ROCE of 9.99%, which is actually below the mid-point of the revalued acceptable range. If the OFT fixes the profitability of Manx Gas through ROCE, who sets prices? Manx Gas still fixes its tariffs and standing charges; but prior to any change it must, under the agreement, consult the OFT. Manx Gas will provide the OFT with detailed evidence, showing how the proposed tariffs and charges will achieve the set ROCE target. Page 2

3 Are you regulating the whole of Manx Gas, or just the gas supply business? The agreement relates purely to gas supply, so other elements of the business (such as appliance sales and property rental) are excluded and will be removed from the accounts. What is to stop Manx Gas setting the prices too high and making excessive profits? Firstly, the calculations will have to stand scrutiny from OFT (with assistance from Treasury accountants). If prices were set too high, there is no benefit to Manx Gas, because if Manx Gas overachieves on its ROCE one year, it has to repay the money to consumers through reducing the standing charge in subsequent years. Do you expect that Manx Gas will achieve exactly 9.99% ROCE? The calculations used by Manx Gas to decide how much gas to forward purchase and what prices to set in advance, rely upon some important assumptions relating to both temperature in the Island (which is the main driver of demand for gas) and projected wholesale gas prices. The reality is that Manx Gas will always under or over achieve in any given year. The agreement deals with this by ensuring that any over performance is repaid to consumers in the following period and any underperformance is recouped. Over time, the average performance of Manx Gas will get closer and closer to the agreed ROCE. How was the agreed ROCE of 9.99% arrived at? The starting point of the negotiations was 10.3%, which was the mid-point of the revalued acceptable range of ROCE. This has already been reduced from the original mid-point of 10.6%. The Government argued (and following negotiation, Manx Gas accepted) that in return for a further reduction of business risk which the agreement offered, the company had to accept less profit. Can capital employed be manipulated by preventing assets from depreciating on the balance sheet or by including cash? The agreement uses only the value of the assets used in the regulated gas supply business as the starting point for calculating ROCE. It ignores those assets on the balance sheet that relate to non-regulated activity. In terms of asset depreciation, Manx Gas has longestablished accounting practices and cannot change them to manipulate the value of its deployed assets. The calculation of the starting point for establishing ROCE relies upon the company accounts, but how reliable is this data? The data is independently audited and false accounting can be a criminal matter. Also, under the agreement, the OFT, supported by Treasury, will see much more detailed data that just the statutory accounts. Page 3

4 Why have Manx Gas profits been secured? The agreement provides Manx Gas with a fair and stable return on its investment; and in return for this, Manx Gas guarantees not to make more than that fair profit. The agreement therefore means that consumers will get a fair price. Equally, the agreement ensures that Manx Gas will continue to invest in the Island s gas network to the long-term benefit of the community and the economy. What are the advantages of fixing profits using ROCE rather than fixing the profit margin on a unit of gas? ROCE is the most appropriate measure for capital-intensive industries as it encourages investment by allowing returns on the asset value. Allowing Manx Gas a capped margin on each unit of gas sold would not encourage investment as there would be less incentive to reinvest back into the business, meaning consumers would likely lose out in the future. If Manx Gas is allowed a guaranteed return, there is no incentive for them to buy gas cheaply. Clause 3 of the agreement sets out Manx Gas obligations under the agreement. One of these obligations is to purchase gas in a manner which provides a balance between best price and the need for stable prices over an annual buying cycle. The OFT does currently, and will continue to, receive information regarding Manx Gas purchase costs and quantities throughout the year. The OFT will monitor this issue closely to scrutinise whether consumers are receiving value for money by benchmarking its performance. If Manx Gas sells less gas (i.e. if people switch to oil) then will Manx Gas raise tariffs to maintain profits? Data published by OFT shows that, over the last five years, the relative costs of oil and gas for central heating might influence a consumer s choice at the time of a new boiler purchase The differential is, however, nowhere near the level to justify someone buying a new boiler and switching fuel types before the existing boiler reaches the end of its working life. This means that any movement of consumers from gas to oil, or vice versa, would be very slow. Sale volumes of gas (and heating oil) are mainly driven by weather. Does this agreement mean that prices will fall? The agreement does not guarantee a reduction in prices since the main factor will be the wholesale price of gas. What it does do, is ensure that prices charged will be lower than what would have been charged had this agreement not been in place. It is very difficult to assess how prices will change, since this means making significant assumptions on the price of wholesale gas. Why are Manx Gas tariffs continuing to rise despite falling wholesale costs? Page 4

5 Manx Gas usually purchases its gas between 6 and 24 months in advance. This hedging allows for stability of tariffs. Without it, tariffs would change frequently, probably several times a year. Manx Gas fixed the current tariff in August 2014 based on its forward purchase price. The gas that is coming out of the pipeline today may well have been purchased up to 2 years ago and will not reflect spot prices (i.e. the price paid for gas purchased today). Gas prices have reduced in the UK. Why have gas prices stayed the same in the island? Each company will have its own hedging strategy, meaning some will purchase many more months in advance than others. The hedging strategies of UK private companies are confidential and cannot be obtained by OFT. The fact that most UK suppliers offer both gas and electricity means they are able to cross-subsidise costs between the two products to a certain extent. The price of oil collapsed during late 2014, surely gas fell by the same amount? For the year to 1 st April 2015 the sterling price of crude oil fell from approximately 65 per barrel to approximately 37 per barrel; a fall of approximately 43%. For the same period the wholesale price of gas from the UK national grid remained approximately the same. Whilst at one stage during the year the gas price had fallen by around 20%, by the end of the period it had recovered to around its April 2014 level. Why is gas more expensive in the Island than in the UK? There are several reasons and these are addressed in detail in the various OFT market investigations. However, there are three principal reasons:- Small scale of purchasing on the wholesale market Cost of transporting gas to the Island through the pipelines Lack of economies of scale in the gas network Is this agreement not just smoke and mirrors? The OFT is committed to maximum transparency and has published the agreement on its website. The agreement itself sets out what can and cannot be published and we will be as open as possible. However, much of the data which the OFT will receive is commercially sensitive. Will you publish the accounts of Manx Gas to prove that the company is complying with the agreement? Manx Gas is a private company and publication of accounts would be a matter for them. The OFT will report regularly on compliance, based on analysis of the confidential data. May 2015 Page 5