i

Review of the Significant ProducerProvisions of the Gas Industry Act 2001

The overriding issue that must be resolved is to create a truly nationalenergy market that is efficient and transcends jurisdictional boundaries.

Energy Markets Review, Commonwealth of Australia, 2002, p. 40.

[I]f the aim of utility reform is to lower final prices for consumers, then. . .1 price discrimination will never lead to higher final prices andmay help reduce these prices. . . . If there is limited entry, thenaccess price discrimination increases the intensity of competitionand leads to lower final product prices. . . . If entry is restricted, thenprice discrimination tends to lower final product prices and raisesconsumer surplus.

Steven King, 1999, p. 33.

Small countries often have limited competition in their natural gas markets,because the markets are not large enough to support efficient operation bya large number of domestic producers or suppliers. In these countriesregulators should focus on lowering entry barriers rather than on regulatingdomestic firms. If entry barriers are low, the threat of entry by …competitors can serve as an effective check on domestic marketparticipants.

Andrej Juris, World Bank (1998: 7).

Lateral EconomicsMay 2003

1 The word ‘access’ is excised here. The paper uses access pricing intelecommunications for the purposes of exposition, but as King explains “While themodel is written for local network access, it clearly applies to any situation where anatural monopoly input is used in final production. Thus, our results are equallyvalid for electricity, gas, water, rail and other utility industries” (p. 25).

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Executive Summary

In order to “ensure that competition is maintained in the Victoriangas market after privatisation” the significant producer provisions(SPP) of the Gas Industry Act prevent producers with substantialmarket power from discriminating against or amongst retailers, andfrom participating in gas retailing. The provision relating todiscrimination is widely drafted, and is far more uncertain in scopethan the provisions relating to similar conduct in the Trade PracticesAct 1974. The producer may breach the Act without intending to, andpenalties are substantial.

Such strong constraints might be justified as part of a largertransitional strategy for the gas industry to underpin investorconfidence as key energy assets were disaggregated and privatised.Today the gas market is national in scope and far more competitivethan it was in 1998. This undermines the case for unusually strongprotections against anti-competitive conduct (beyond existingsafeguards in Part IV and IIIA of the Trade Practices Act)

However, even if unusually strong protection for some transitionalperiod was thought necessary, analysis suggests that the SPprovisions were excessively restrictive. Price discrimination (broadlyunderstood to include differentiation in product design, quality, andproduct bundling) can be a concern where a dominant supplier isvertically integrated into a competitive stage of production. (Even soeconomic analysis suggests that even with vertical integration, pricediscrimination will generate more benefits than costs.)

But where a producer is not vertically integrated, or is prohibitedfrom vertically integrating, constraints on price discrimination seemperverse. Where it is not vertically integrated, the dominantproducer has no motive to discriminate between downstreamcustomers except to extend its market, an inherently pro-competitivegoal.

When fixed costs are large – as is the case here – marketparticipants down the production chain require the freedom tospecialise and to find ways to jointly meet fixed cost investments.This is illustrated most clearly in a simple model of monopoly, wherea ‘strong’ monopolist who can price discriminate generates thecompetitive level of output. Here price discrimination permits it tosupply more marginal customers by charging them less.Constraining price discrimination in such circumstances is a recipefor returning from the efficient level of output to the less efficient levelinvolved where a monopoly is required to charge a single price.

A richer understanding of the actual conditions of the gas industry –the ubiquity of fixed costs and indivisibilities, the need to co-ordinateproduction, transmission and distribution efficiently – strengthens thecase for reform.

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The three major Victorian retailers pursue quite different ‘niche’strategies (See Appendix Three). Thus each has quite differentpreferences in their gas demand. In such circumstances,constraining differentiation at the wholesale level would seem to bean extremely serious matter. It

• impedes the market development inherent in closer integrationbetween producer and existing customers and

• impedes the emergence of new retailers who would wish tosecure that their specific needs were met if they were to enterthe market.

The constraints within the SP provisions are magnified by legaluncertainty. Penalties can be as much as $10,000,000 but onlyproducers can be liable. And all that is necessary to raise thespectre of liability is the spectre of one retailer feelingdisadvantaged, that disadvantage reducing their competitiveness,and their mounting a plausible argument that this is likely tosubstantially lessen competition. With only three major retailers,some might consider damage to any one of them to be a ‘substantiallessening of competition’.

Given the problems, and the asymmetric penalties, lawyersgenerally advise against discriminatory support of marketdevelopment, because of the legal uncertainties to which it wouldgive rise. In this regard, as in other respects, the SP provisions arerevealed as a recipe for a quieter life for all concerned – but a lesscompetitive one. For regulation that could only be justified if itseconomic benefits outweighed its costs, it is sobering that itsintended beneficiaries – the retailers – are understood to oppose it.

These arguments are strengthened on consideration of the recentDawson Review of the Trade Practices Act. It embraces theproposition put forward in the Hilmer review that price discriminationthat is not proscribed by existing provisions of the TPA – particularlysection 46 – is likely to be efficiency enhancing. Accordingly itargues against re-introducing any special treatment for pricediscrimination into the Act.

The case against retaining the SPP is reinforced further by therecent Parer Review, which found that there were too manyregulators adding unnecessary cost and impeding interstate trade.

In sum, as a mechanism for promoting competition within the retailgas market and, more broadly, the energy market, the significantproducer provisions are counterproductive. They render the gasmarket less competitive, less flexible, less responsive and so lesseconomically efficient. Repealing the SPP and allowing the Victoriangas market to play its part in a truly national market will promote thecompetitive outcomes sought by those who introduced the SPP.

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Table of Contents

Executive Summary ii

Table of Contents 4

1 The economic rationale of the significantproducer provisions (SPP) 5

2 The economics of price discrimination –the simplified model of market power 6

3 The economics of price discrimination –indivisibilities, fixed costs and the real world 7

The commercial imperatives of gas supply ................ 7

Interstate trade is already undermining SPP ..................10

Legal uncertainty as a barrier to co-ordinationand market development..............................................11

4 Restrictions on significant producers retailing 13

A note on vertical integration and price discrimination.................. 13

5 The need for other State specific legislation in addition to the TradePractices Act 1974 14

The Dawson Review....................................................15

The Parer Energy Market Review .................................16

Appendix One: The objectives of the 1998 legislation 18

Appendix Two: Monopoly and discrimination 20

Appendix Three: Victorian gas retailers and their retail strategies 23

TXU............................................................................23

AGL............................................................................23

Origin .........................................................................23

References 25

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1 The economic rationale of thesignificant producer provisions (SPP)

The regulation under review is economic regulation. To ensure itachieves its objective of improving economic efficiency it should besoundly based in economic reasoning. Yet there are strong groundsfor believing that the significant producer provisions (SPP) haveprobably always impeded economic efficiency, that any positive roleit may have played was in the transition to a competitive nationalmarket, and that that time has clearly passed.

The overriding objective of the SPP appears to be to “ensure thatcompetition is maintained in the Victorian gas market afterprivatisation”. The mechanism that was chosen was to limit theparticipation of significant producers in the wholesale gas market, ofwhich at that time there was only one, Esso/BHP (See AppendixOne).

There is often a tension in competition policy between the form ofcompetition – as measured by the number of competitors – and thesubstance and ultimate purpose of competition. This is to deliver themost cost-effective products to market.2

Many, if not all, market actions with which competition policyconcerns itself reflect this tension. On the one hand a substantialplayer in a market will seek to make itself economically stronger.Other things being equal, this would be good for efficiency and forthe vigour of competition. However, competition policy must take aview when other things are not equal – when the strength of onemarket player may unduly weaken other market players.Judgements must be made about the economic trade-off betweenthe efficiency enhancing effects of strengthening one firm and thepotentially harmful effects of reduced competition.

The significant producer provisions stand out as different in thiscontext of promoting competition. It imposes two constraints onproducers that may exercise market power within a Victorian market.Section 37 prevents them from vertically integrating downstream byprohibiting them from selling gas to retail customers whose demandis below 500,000 GJ per annum. Section 78 outlaws ‘anti-competitive’ discrimination between retailers with a much lighterburden of proof than is required in the national economy wideprohibition of anti-competitive conduct embodied in the TradePractices Act 1974. Thus section 78 can be triggered wherever a

2 This tension is well illustrated in merger policy. By definition mergers reduce thenumber of competitors and some lessen competition. But most mergers enhancecompetition by strengthening competitors and so permitting more vigorous andbeneficial competition.

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significant producer “discriminates among or against gas retailers ina manner that has the purpose, or has or is likely to have theeffect, of substantially lessening competition in a Victorian gasmarket.”

On its face the blanket prohibition on significant producers retailingclearly restricts competition. And it does so in an industry with onlythree major competitors.

The legislation also offends against all Australian governments’current policy of regulatory parsimony or ‘minimum effectiveregulation’ (Commonwealth Treasury, 2001, p.37). In somecircumstances, competition policy might rightly concern itself withconstraining the vertical integration of a dominant producer, or withpreventing it from discriminating in favour of its downstreamsubsidiary and against other customers. But as is argued below, it isexceptionally hard to find a rationale well grounded in economicanalysis for doing both.

With substantial uncertainty as to how the market would eventuallyoperate, the Victorian Government may well have had worthwhileobjectives for implementing the SPP as part of a larger transitionalstrategy for the gas industry. Even though from a theoreticalperspective the competition policy protection was excessive, it wasan understandable price to pay for investor confidence as keyenergy assets were disaggregated and privatised.

Though the legislation was not explicitly ‘sunsetted’, both contextand public statements at the time, including advance provision forthis review, suggest that the regulation was transitional.

It follows that even without the profound deepening of competitivepossibilities in the Victorian and Australian energy and gas marketsthat has taken place, it would now be time to repeal the regulation.In fact, as set out in ExxonMobil’s submission, the deepening of themarket, the intensification of competition within the Australian andVictorian markets simply increases the costs of the regulation, andreduces to negligible levels any possible benefits it might have had.

2 The economics of price discrimination –the simplified model of market power

In the simple model, price discrimination is necessary for optimisingefficiency where large fixed costs must be funded and producershave market power.

The clearest understanding of the economics of price discriminationcomes from considering a simple model and the polar cases of‘strong’ and ‘weak’ monopoly – where a firm with market power canand cannot price discriminate between its customers respectively.This model is set out at Appendix Two.

The following conclusions follow from the discussion in the appendix:

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• Price discrimination is clearly an expression of marketpower. Fully competitive markets do not exhibit pricediscrimination, which dissipates as competitors enter amarket.

• The producers’ motive to maximise its profits brings abouta transfer of surplus to itself from its customers. Moreparticularly;

• where the monopolist uses its market power to chargeabove average cost it captures consumer surplus bydoing so but will never forgo sales by doing so.Accordingly it does no harm to economic efficiency bycapturing this rent.

• Where a monopolist charges below average cost, pricediscrimination is the means by which economicefficiency is improved by extending the market of themonopolist to the efficiency maximising point, wherethe marginal cost of the last unit of production is equalto the marginal benefit.

• The corollary is that where price discrimination is notpossible, economic efficiency falls back to the simplemonopoly case, where the producer constrains supply to aprofit maximising level below the point at which marginalbenefit equals marginal cost.

• Where there are high fixed costs, which ensuresimperfections in competition,3 price discrimination isindispensable to achieving the most efficient outcome.Weakening a ‘strong’ monopolist is thus unambiguouslybad for economic efficiency.

The next section, which considers the gas industry and the pointsmade above in a more general and richer context, drives home theway in which these theoretical considerations shape the commercialand economic development of the gas industry.

3 The economics of price discrimination –indivisibilities, fixed costs and the real world

The commercial imperatives of gas supply

Economies of scale and high fixed costs make economic analysis ofmarkets much more complex, and this limits the scope forunambiguous conclusions. Nonetheless, the complexities reinforce

3 We exclude the possibility of government subsidies of fixed costs to allow theproducer to charge marginal cost to all buyers. Apart from its impracticality, itgenerates losses because it requires additional taxation.

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arguments for freedom of contract. When fixed costs become moresignificant, market participants require the freedom to specialise andto find ways to jointly meet fixed cost investments. For example,Krugman (1978) argued that models of trade that incorporate fixedcosts and imperfect competition complicate, but ultimatelystrengthen the case for free trade (1978). This section argues thatthe same can be said for freedom of contract within Victoria’s gasindustry.

Throughout the production chain, the gas industry is rife withindivisibilities, interdependencies of production and consumption,and economies of scale. Exploration involves the sinking of hugefunds in the search for natural resources that, once discovered, yieldeconomic rent. Production requires substantial investment and fixedcosts dominate transmission and reticulation. In many applications,fixed costs are also substantial in consumption and high capitalcosts are associated with switching energy sources.

Optimal resource and industry development results from a mappingof consumption possibilities across the market with distributionpossibilities across the grid, and production possibilities across thefield. Additional investment is considered as part of the equation ateach stage of production and consumption. Each requires a varietyof permits from government authorities. The whole process –summarised in the diagram below, takes around two years tocomplete and only one in four such negotiations are concludedsuccessfully.Steps in securing a major gas development – gas-fired generation

ForecastPower Generation

Capacity Gap

GasSupply

GasTransport

ElectricityTransmission

Host Site/Operator

Developer

Capacity

CompetingSales

Opportunities

CorporateCapital &

DevelopmentResources

CompetingProjects

BusinessDiversity

CorporateCapital &

DevelopmentResources

CompetingProjects

CompetingElectricity

SupplyOffers

BusinessDiversity

CorporateCapital &

DevelopmentResources

CompetingProjects

BusinessDiversity

CorporateCapital &

DevelopmentResources

CompetingProjects

CustomerCustomer

Customer

CustomerCustomer

Joint optimisation of consumption, distribution, and productionpossibilities depends on more than price, and, as Wolfstetter notes

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(1999; p.25) “a full account of price discrimination cannot be given interms of price alone. Pricing is interconnected with product design,quality, and product bundling”. Different gas consumers havedifferent capacities to pay and quite different physical supplypreferences. For some, the reliability and timing of supply arecritical. Others are more tolerant of variability especially if theirtolerance relaxes some constraint for their supplier(s) who canrespond by offering them a lower price or other favourable terms.

With so much to co-ordinate, it would seem a very serious matter tojeopardise the individualisation of specific contracts at the wholesaleinterface between producers and consumers – particularly wherefreedom to tailor specific contracts may be important to facilitatingfurther market entry in retailing.

It is for these reasons that the ACIL consultancy report reviewing theNew Zealand gas industry commissioned by the New ZealandMinistry of Economic Development (2001, p. xi) argued;

Wholesale efficiency requires an absence of barriers totrading, a range of contractual arrangements of differinglength, differing "quality" (e.g. delivery reliability) andimportantly, no limitations on re-selling.

Although in the simple theoretical model, the deeper a marketbecomes the less price discrimination is possible or necessary, infact as markets deepen, they also become more complex.4 Ascompetition intensifies, firms are likely to seek ‘niches’ in the market.Their incentive to do so is to enhance their profitability (and indeedtheir market power within the sub-market they are developing). Yetthis kind of market power is unambiguously efficiency enhancing.For the new market power is enjoyed only as the result of firmsgenerating specific and valuable know-how, and capabilities thatrival firms in the industry provide less effectively. It is Adam Smith’sgains from specialisation at work.

The Victorian gas market provides a textbook case of thisphenomenon (See Appendix Three). As the ExxonMobil submissionoutlines, the three major retailers each pursue quite different ‘niche’strategies to secure their future. Thus each has quite differentpreferences in their gas demand. This means that each valuesdifferent things in their negotiations with suppliers. In such

4 Although much has been made of the gradual move away from 'project supply' to'commodity supply', the indivisibilities remaining always mean that close co-ordination between buyers and sellers of gas remain important right down theproduction chain. Thus even in the deepest most competitive market in the world -the United States - the gas market retains critical institutions from shallowermarkets to manage risk, fund fixed costs and co-ordinate preferences down theproduction chain. Today in the United States longer-term contracts still dominatethe spot market with substantial differentiation between buyers with differentpreferences.

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circumstances, constraining differentiation at the wholesale level isto impede the market development inherent in closer integrationbetween producer and customer.

Any differences in contractual provisions between the major retailerscould arguably breach the legislation (Indeed it is not impossible thatidentical provisions with differential impacts on retailers would attractsection 78 of the Act – see below). All that is necessary is that atleast one retailer feels disadvantaged, that disadvantage reducestheir competitiveness, and that this could be taken to substantiallylessen competition. Where there are only three major retailers,some might consider damage to any one of them to be a ‘substantiallessening of competition’.

Of course it is in the interests of a significant producer to draw outthese problems – the SP provisions unambiguously constrain andimpede its freedom of action. What should be more persuasive stillfor policy makers is the fact that the parties who are the intendedbeneficiaries of the regulation – the retailers – are understood byExxonMobil to also oppose the provisions. So, although much of thecost of the regulation is borne by the producer, any ‘protection’ itgives retailers from a significant producer’s market power isoutweighed by the lost opportunities in closer integration at thewholesale interface between producer and consumer.

Interstate trade is already undermining SPP

Underlining the more general point that we should now beconsidering the Victorian gas market in the context of the broadernational gas market – and the Victorian and national energy markets– interstate trade in gas is now undermining Victoria’s uniquesignificant producer provisions.

We have argued above that the SP provisions constrain producersfrom assisting new entrants into the gas market. By contrast they dono such thing in markets outside of Victoria. Thus ExxonMobil isnegotiating a substantial supply contract to supply gas to a newentrant in the NSW gas market – with an ability to meet the newentrants needs which it would not have under the shadow ofVictorian legislation.

And where Victorian exports of gas to other jurisdictions illustratesthe way in which the SP provisions actively harm thecompetitiveness of the Victorian gas market, so too does the way inwhich imports of gas can do the same thing. Gas can be suppliedinto Victoria by suppliers from other states – including from Victorianbased processors of gas produced from gas fields outside Victorian

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territorial waters such as at Yolla.5 Thus, a Victorian desire toprevent discrimination between its own gas retailers has theperverse result of discriminating against Longford gas in favour ofgas imported from other states! The retention of such regulation canonly be expected to undermine the confidence of senior decision-makers within producer firms when considering investment inVictoria.

Legal uncertainty as a barrier to co-ordinationand market development

The penalties of up to $10,000,000 contemplated by section 91 ofthe Act are onerous enough. But the legal uncertainties to which theSP provisions give rise are of greater concern. The producer is theonly party that can be liable for penalties under these provisions ofthe Act.

The SP provisions do not define the discrimination they are seekingto proscribe beyond noting that it must be anti-competitivediscrimination. We have argued that at least in the absence ofvertical integration, discrimination only makes sense for a producer ifit is assisting it to expand its market – an inherently pro-competitivegoal. But how can a producer do so without at least riskingdiscrimination within the meaning of the Act?

Consider the following example. A retailer wishes to undertake amajor storage and demand-side management investment andreduce gas off-take at peak periods. The retailer cannot fund thisexcept from some of the benefits it generates for the producer. Theproducer duly agrees and reduces the unit price of gas to theretailer. However, the new, lower price and the additionalinvestment of the first mover in the retail market could have aserious effect on a competitor raising the spectre of discriminationunder the SP provisions.

In the circumstances of the example the producer has shared in thefunding of the first retailer’s investment. The marginal benefits of asecond retailer replicating this strategy may be much smaller. Sothe producer cannot offer a similar reduction in unit price to thesecond retailer.

But it is not at all clear that making identical offers to all customersabsolves the producer from discrimination under the Act, for it wouldnot be difficult to come up with terms – ostensibly offered to all

5 It is worth noting that the way the legislation is drafted, ExxonMobil may not beable to escape the provisions of the SPP even if it were to import its own gas fromother jurisdictions – for instance from the Cooper Basin.

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retailers – that are of much greater benefit to some than to others.6Might this be anti-competitive discrimination within the meaning ofthe Act?

In effect, all aspects of contracting by significant producers arecapable of falling within the ambit of discrimination. This couldinclude the contractual provisions relating to gas off-take during peakand off-peak periods, priorities during any interruption to supply,arrangements with retailers due to problems arising with a retailnetwork, etc.

There are yet other problems of uncertainty. Once a competitionnotice has been issued (under section 83) and submissions havebeen heard, the regulator can order that the offending marketconduct is to cease (section 90). This prevents the producer fromhonouring its contract raising several vexing issues. In suchcircumstances the producer may have no choice but to exercise theSPP termination clause in the supply contract. 7 Thus a Victorianretailer may scuttle a supply contract of a competitor by arguing thatit was not offered identical terms and conditions, but only if thatsupply contract was with a Victorian producer. This risk attaches toall supply contracts written by a Victorian producer, and potentiallydisadvantages all market participants, producers and retailers alike.

Authorisation processes (which are provided for within the SPP) areintended to address these matters, but in practice they imposeheavy costs. The legal and analytical work required in such aprocess is highly costly in its own right. But the delays anduncertainties to which it gives rise are likely to dominate and bestrongly efficiency impairing.

Given the problems, and the asymmetric penalties, it is notsurprising that lawyers will generally advise against the kinds ofproducer support for new developments that could conceivably fallwithin the ambit of discrimination, because of the legal uncertaintiesto which it would give rise. In this regard, as in other respects, theSP provisions are revealed as a recipe for a quieter life for allconcerned – but a less competitive one.

6 For instance volume discounts offered across the board would disadvantagesmaller retailers. Unusually heavy discounts for off peak supply would favour thoseretailers with greater storage and demand management capability.

7 Since the SPP have been enacted it has become customary to include suchclauses in wholesale contracts.

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4 Restrictions on significant producersretailing

A note on vertical integration and pricediscrimination

As observed above, the prohibition of both price discrimination andvertical integration is excessive. Without vertical integration it is hardto see how a producer’s discrimination between customers could bedriven other than by a desire to extend its market. Any other kind ofdiscrimination would by definition simply bring about a redistributionof the producer’s supply from one customer to another.

It is worth noting that even if there is vertical integration, and even ifthe producer’s vertical integration leads it to discriminate in favour ofits own subsidiary unfairly, discrimination between customers is stilllikely to be essential to finding the most efficient market outcome.Thus, making plausible assumptions about technology, King findsthat (1999, 33)

. . . if the aim of utility reform is to lower final prices forconsumers, then access price discrimination will never lead tohigher final prices and may help reduce these prices.

The intuition behind the result can be understood as follows. As apreviously existing constraint on vertical integration is relaxed:

• There are clear gains in productive efficiency (if theproducer enjoys economies of scope in movingdownstream).

• Increased competition lowers prices to consumersimproving their welfare.

• The producer nevertheless takes some of the economicbenefit by discriminating against its downstreamcompetitors and in favour of itself. This leads to somemisallocation of resources between downstreamcompetitors but this is not enough to undo the good arisingfrom lower costs and prices to consumers.

Section 37 of the Gas Industry Act restrains significant Victorianproducers within the meaning of the SPP from entering the retailmarket. In so constraining its market to less than the 40 largestcustomers, the Act has clear costs especially in a retail market whichcontains only three major competitors. Rather than arbitraryrestrictions based on the amount traded, the Trade Practices Act1974 (discussed below), by comparison, regulates market behaviourirrespective of the amounts traded as between market participants,and provides an effective mechanism for ensuring thecompetitiveness of wholesale and retail arrangements.

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Cogeneration options for large consumers could be constrained byan inability to access gas directly from the producer. If a partysought gas for cogeneration in amounts less than 500,000 GJ perannum and at the same time intended to sell excess energy backinto the retail market it would be forced to buy from potentialcompetitors. Given the level of concentration in gas retailing, theterms of such a purchase might not be so favourable as to facilitatereal competition.

What might have appeared to be pro-competitive regulation, turnsout in fact to be its opposite. By constraining the behaviour ofsignificant producers, the legislation impedes a critical force in thedevelopment of the industry.

Note that the SP provisions are intended for retailers’ protection andKing’s analysis suggests that there is a risk that a producer mightdiscriminate against any downstream competitors. Even so,ExxonMobil understands that Victorian gas retailers are so aware ofthe costs they impose that they oppose the SPP.

To summarise, the legislation:

• Protects existing retailers by preventing producers fromsupporting new entrants to the retail market and restrictinginnovative energy generation such as cogeneration –though the legislation’s unpopularity with retailers points tohow its costs outweigh its benefits even for its intendedbeneficiaries;

• Restricts the ability of retailers to compete as betweenthemselves where that competition would requirenegotiation of differential supply arrangements with asignificant producer, because such an agreement wouldplace the significant producer at risk of breaching the SPP;and

• Protects existing retailers through preventing significantproducers from participating in all aspects of the marketincluding the retail market.

As a mechanism for promoting competition within the retail gasmarket and, more broadly, the energy market, the significantproducer provisions fail because they cannot achieve the statedaims. The result is that the retail gas market becomes lesscompetitive, less flexible, less responsive and less efficient.

5 The need for other State specificlegislation in addition to the Trade PracticesAct 1974

The wider context within which this review takes place concerns thedeveloping national energy market. The national energy market

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does not imply an abandonment of state responsibilities, so much asa clearer delineation of responsibilities. Differences in circumstancesand perceptions as between States will continue to justify someState-specific legislation, in particular where that regulation does notimpinge on the free play of market forces within the national energymarket. Thus for instance, different states might wish to providedifferent levels of protection to consumers or to native title interests.But once states express their preferences within their ownjurisdiction the essence of good policy is to allow free competitionbetween (and within) states to be the preferred constraint on themarket power of any player.

None of this is to suggest that there should be no constraint onproducers – such as ExxonMobil – or powerful retailers for thatmatter. But we already have general rules for striking the difficultbalance between protecting competition and allowing firms to act tostrengthen their own position and, by doing so, strengthen the vigourof competition in serving end consumers. Those rules are not – asthey need not be – specific to any industry or any state. They areembodied in the Trade Practices Act 1974 and these are the rulesthat should govern competitive behaviour in the Victorian gasindustry.

The Dawson Review

The arguments presented earlier are strengthened on considerationof the recent review of the Trade Practices Act (The DawsonReview), completed in January 2003. It proposes no weakening ofthe competitive conduct provisions of the Act in particular the misuseof market power provision (section 46).

The review also considered whether or not there was a weakness inthe act since the 1995 repeal of section 49, which dealt specificallywith price discrimination. The review re-iterated contemporaryappreciation of the importance of price discrimination in improvingeconomic efficiency in the presence of fixed costs. It quoted theHilmer Review as concluding that “price discrimination generallyenhances efficiency” except for circumstances where it is an abuseof market power and thus covered by other provisions of the TPA (p.89). The Dawson Review continued:

As the Swanson Committee observed in 1976, it is priceflexibility which is at the heart of competitive behaviour and ageneral prohibition against price discrimination wouldsubstantially limit price flexibility (p.93).

It accordingly recommended (p.97) that “[n]o change should bemade to the Act in relation to price discrimination”. This was notbecause price discrimination could never harm the economy, or thatlegally constraining it might not be appropriate in the rightcircumstances. The Dawson Review concluded that “the effect of

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price discrimination on competition needs to be assessed on a case-by-case basis” and that accordingly (p. 96), “Section 46 of the Actprovides an appropriate means to tackle anti-competitive pricediscrimination. There is no case for the reintroduction of a prohibitionagainst price discrimination.”

The Parer Energy Market Review

In the majority of cases, and certainly in Victoria, producers in oneState are exposed to competition from other States. Today gas ongas competition is a reality in Victoria within the larger competitiveconstraints provided by the broader energy market. Substantialcompetition is already possible given existing pipeline infrastructure.New production is imminent from several gas resources in Victorianand Tasmanian waters not to mention the prospect of gas fromNorthern Australia and Papua New Guinea already intruding intolonger term gas contracting in Victoria.

All this underscores the wisdom of the central thrust of the ParerReport in placing “a truly national energy market that is efficient andtranscends jurisdictional boundaries” at the centre of its deliberations(Commonwealth of Australia, 2002; p.40). The Committeeaddressed a range of issues concerned with effective integration ofState-based energy markets and the creation of an effective andefficient national energy market commenting that:

Energy market governance and regulatory arrangements areof considerable concern to key stakeholders. A consistentview in submissions to the Review is that regulatoryarrangements, for both natural gas and electricity are notoptimal and are impeding market development. (p.41)

The Committee found (p.44) that “[t]he widespread uneasesurrounding present governance and regulatory arrangements isjustified. The governance arrangements are confused and there isexcessive regulation”. The Committee found that there wereperceptions of conflict of interest where governments were owners,regulators and policy makers. Clearly oversight at a national levelmitigates this risk.

A key finding was that there were too many regulators with theCommittee noting that the multiplicity of regulators creates a barrierto competitive interstate trade and adds costs to the energy sector.The present arrangements are inappropriate for a situation in whichcross-border energy flows are now a reality (p. 44).

The Committee made a number of recommendations on governanceand regulatory arrangements (Chapter 2), all of which recognise theneed for a national approach to energy market regulation.Specifically, recommendation 2.1 (p.57) states:

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A sector-specific statutory National Energy Regulator (NER)should be established to be the independent energy regulatorin all jurisdictions, interconnected or otherwise, and toencompass the energy-related regulatory roles of the ACCC,NECA and state and territory regulators.

The recommendation to establish the NER (amongst other nationalenergy industry regulators) does not involve the displacement of theACCC’s national role of administering the restrictive practices of theTrade Practices Act 1974 (p. 9).

If a jurisdiction were to retain its own competition legislation in thepresence of the NER, market participants would be confronted withthree regulators with responsibilities relevant to competitivebehaviour, the ACCC, the NER, and the State regulator. This wouldincrease uncertainty and compliance costs without any apparentbenefit. It would also be inconsistent with the objectives of creating anational energy market with consistent and uniform regulation acrossjurisdictions.

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Appendix One: The objectives of the 1998legislation

The Gas Industry (Amendment) Act 1998 specified the purpose ofthe amendment as:

to make provision regulating certain anti-competitive conduct,to restrict cross-ownership in the gas industry and to makecertain other amendments to the Gas Industry Act 1994(Section 1).

In the second reading speech on tabling of the Gas Industry(Amendment) Bill 1998, the then Treasurer, Mr Stockdale, statedthat:

The bill is an integral part of the government's gas industryreform program which has been carefully designed to deliversignificant benefits to the state by creating a morecompetitive, open and responsive gas supply industry. Thisbill will ensure that competition is maintained in the Victoriangas market after privatisation.

In order to achieve this, the bill principally introducesamendments to the Gas Industry Act 1994 (the act) designedto prevent significant producers from engaging in anti-competitive conduct and creates a cross-ownership regimewhich will ensure that after privatisation the structure of thegas industry in Victoria remains competitive.

The significant producer provisions of the bill target suppliersof gas to the Victorian wholesale gas market who have theability to exercise power in that market. Significant producersare prohibited from engaging in conduct which discriminatesamong gas retailers in a manner which has the purpose, orhas or is likely to have the effect, of substantially lesseningcompetition in a Victorian gas market. One aim of thisprovision is to ensure that significant producers do not engagein anti-competitive conduct which creates disincentives forgas retailers to seek alternative sources of gas supply.

The provisions relating to significant producers deal with anti-competitive conduct (section 78) as follows:

A significant producer engages in anti-competitive conduct ifthe significant producer discriminates among or against gasretailers in a manner that has the purpose, or has or is likelyto have the effect, of substantially lessening competition in aVictorian gas market.

Section 79(1) proscribes anti-competitive conduct as defined insection 78.

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Section 37 of the Gas Industry Act 2001 restricts the participation ofsignificant producers in the retail gas market to purchasers of notless than 500,000 GJ per annum:

Despite anything to the contrary in any licence to sell gas byretail held by a significant producer, that licence does notauthorise the sale of gas from a supply point to a personunless—

(a) the person has purchased not less than 500 000 GJ ofgas from that supply point, or an ancillary supply point,during the 12 months immediately preceding 1 September1998 or the commencement of the supply, whichever isthe later; or

(b) the supply point is new and the Commission issatisfied on reasonable grounds that the person willpurchase not less than 500 000 GJ of gas from thatsupply point within a period of 12 months during theperiod of 3 years next following the commencement ofsupply;

The legislation seems to have been framed on the basis that theparticipation of significant producers in the wholesale gas market,other than under the terms and conditions specified in the Act, is perse anti-competitive. Furthermore, in proscribing acts that have anti-competitive effects or are likely to have such effects in addition to thesubjective test of having the purpose of doing so is clearly imposes amore broad and uncertain test of liability than the relevant section ofthe Commonwealth Trade Practices Act 1974. In that Act, section46 applies where parties can be shown to misuse their market powerwith the purpose of restricting competition.

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Appendix Two: Monopoly and discrimination

Market power in its purest form is associated with monopoly. If themonopolist has a ‘weak’ monopoly it can set a single price thatapplies equally to all customers (Wolfstetter, 1999; p.5). Under theseconditions the profit maximising monopolist equates marginal cost,MC, with marginal revenue, MR. This is not anti-competitivebehaviour; it is profit maximising behaviour on the part of themonopolist. Defining welfare in terms of maximising the sum ofproducer and consumer surplus, the weak monopoly outcome iswelfare inferior to the perfectly competitive outcome. Total surplus isnot maximised and there is a deadweight loss associated with themonopoly.

Strong monopoly exists where the monopoly has full control over theprice function.

He can . . . charge different prices to different buyers. In otherwords, the strong monopolist can use all his imagination todesign sophisticated pricing schemes to pocket the entire gainfrom trade, restricted only by consumers’ willingness to pay(Wolfstetter, 1999; p.4).

The perfectly competitive outcome results in a price, Pc, and quantitysupplied, Qc. Consumer surplus is the area ADPc, producer surplusis the area PcDO, and the total cost of supply is ODQc. Welfare ismaximised. A weak monopoly equates MC with MR, and supplys Qm

(<Qc) to the market. Customers all pay the same price, Pm.Consumer surplus is ABPm, producer surplus is PmBCO (includingan economic rent of PmBCMC), and there is a deadweight loss ofBDC. The weak monopolist restricts supply to maximise profitresulting in a lower quantity being available to the market at a higherprice. The outcome has distributional implications, the monopolistcaptures more of the surplus, and efficiency implications, there is adeadweight loss.

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Monopoly

MC

ARMR

Pm

MR=MC

Qm Qc

ER

A

B

C

O

DPc Strong monopoly

Weak monopoly

Intuitively it might be concluded that strong monopoly is welfareinferior to weak monopoly, and a strong monopolist should beconstrained to operate as a weak monopolist, assuming thatcompetitive market conditions cannot be approximated. However, astrong monopoly can implement perfect price discrimination, whereeach customer is charged their maximum willingness to pay, and thismaximises surplus and there is no deadweight loss.

Refer again to the Figure. The strong monopolist can capture theentire surplus by charging each customer their maximum willingnessto pay (perfect price discrimination), that shown as the line AR. Astrong monopolist that fails to supply up to the quantity, Qc, issacrificing additional profits. If the strong monopolist supplies Qm, itwill forego additional profits of BDC. Strong monopoly is welfaresuperior to weak monopoly, because strong monopoly maximisessurplus and there are no deadweight losses. Although the entiresurplus accrues to the monopolist this does not per se provide ajustification for limiting a strong monopoly to behave as a weakmonopoly.

The assumption underlying the SPP appears to be that, as at 1998,there was a significant producer that was capable of and likely toengage in discrimination as between retailers in the retail gasmarket. This assumption is reinforced by the statement in the IssuesPaper (ESC, 2003; p.12) where the ESC says that its review of theSPP will:

involve assessing whether competitive developments in thegas market since the legislation was enacted have beensufficient to eliminate the capacity and incentive of significant

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producers to misuse their market power by discriminating anti-competitively between gas retailers.

Assume that in 1998 the market circumstances were such that asignificant producer did have the capacity and incentive todiscriminate as between gas retailers; that is, the significantproducer was a strong monopolist. The SP provisions constrain thestrong monopolist to operate as a weak monopolist, because for thesignificant producer to do otherwise would risk breaching theprovisions of the Act. The outcome is that the significant producersupplies less gas into the retail market and there are feweropportunities for marginal retailers to access gas supplies. The resultis a less competitive retail gas market with fewer retailers. Economicefficiency is reduced and social welfare is not maximised.

In addition, the lower returns to the regulated weak monopolyarrangement as compared with those that would have accrued to thestrong monopoly dilute the market signals received by other potentialsuppliers of gas. That is, the Victorian retail gas market appears tohave lower demand and be less profitable than would be the case inthe absence of the SPP.

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Appendix Three: Victorian gas retailers andtheir retail strategies

TXU

Market share in Victoria – approximately 40%

• Also a retailer of gas and electricity in South Australia.

• Owns of electricity retail/distribution assets in Victoria.

• Owns of one the three major franchised gas retail/distributioncompanies in Victoria.

• Purchased when privatised and now operates the WesternUnderground Gas Storage in Victoria.

• Hedge agreement establishing TXU control of Newport &Jeeralang gas fired peaking power plant in Victoria.

• Purchased power station site in NSW from Government fordevelopment of gas fired generator later this decade.

• Owner of Torrens Island gas fired power station in SouthAustralia.

• Owner of transmission pipeline assets ring fenced from its retailbusiness, including interest in SEAGas pipeline.

• Does not own gas production assets.

AGL

Market share in Victoria – approximately 30%

• Retailer of gas, electricity and LPG in Victoria & NSW.

• Major retailer and owner of gas distribution system in NSW.

• Owner of electricity retail/distribution assets in Victoria.

• Owner of one of the three major franchised gas retail/distributioncompanies in Victoria.

• Owner of transmission pipeline assets ring fenced from its retailbusiness, notably the main NSW transmission system.

• Does not own gas production assets.

• Owner of gas fired power generation & cogeneration projects.

• Owner of underground LPG cavern storage facility in NSW(50%)

Origin

Market share in Victoria – approximately 25%

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• Retails gas in all Eastern and Southern Australian States (Vic,SA, NSW, Qld, NT).

• Retails electricity in Victoria and LPG in Australia, NZ, and thePacific.

• Owns of electricity retail/distribution assets in Victoria.

• Owns of one the three major franchised gas retail/distributioncompanies in Victoria.

• Owns gas fired power stations in South Australia

• Owns transmission pipeline assets ring fenced from its retailbusiness, including interest in SEAGas pipeline.

• Owner of LP gas import facilities.

• Vertical integration strategy with gas production assets in whichit has an interest in order to fulfill its own retail demand.Interests in Cooper/Eromanga producing fields and activelydeveloping new gas production assets (Yolla,Thylacine/Geographe, Qld CSM).

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References

ACIL Consulting, (2001). Review of the New Zealand Gas Sector: AReport to the Ministry of Economic Development,http://www.med.govt.nz/ers/gas/review/acilreport/acilreport.pdf

Commonwealth of Australia (2002) (Parer Committee), Towards aTruly National and Efficient Energy Market: Council of AustralianGovernments Energy Market Review, Nov 2002.

Commonwealth of Australia (2003) (Dawson Review), Review of theCompetition Provisions of the Trade Practices Act, January 2003.

Commonwealth of Australia, Treasury, (2001), Competition PolicyAnnual Report.

Juris, A. (1998). “The emergence of markets in the natural gasindustry”, World Bank Working Papers, No. 1895, March 1, WorldBank.

King, S.P., 1999. Price Discrimination, Separation and Access:Protecting Competition or Protecting Competitors? AustralianJournal of Management, Vol. 24, No. 1.http://www.agsm.unsw.edu.au/eajm/9906/king.html.

Krugman, P., 1978. "Comment" on Corden's Paper "Intra-industryTrade and Factor Proportions Theory", in Giersch, H. (ed), On theEconomics of Intra-Industry Trade, Symposium, Kiel, pp. 13-17.

Wolfstetter, E (1999), Topics in Microeconomics: IndustrialOrganisation, Auctions, and Incentives, Cambridge University Press,Cambridge UK.