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    [Premium] Thierry Bros: Nord Stream and Uber – Cutting Cost of Transport (Comment)

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This paper could be viewed by some as politically incorrect but I challenge anyone to view it as economically illiterate!   In theory...

by: Thierry Bros

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[Premium] Thierry Bros: Nord Stream and Uber – Cutting Cost of Transport (Comment)

This paper could be viewed by some as politically incorrect but I challenge anyone to view it as economically illiterate!

 

In theory, regulators are there to protect consumers and to provide the industry with a level playing field. In practice, this doesn’t work. Remember taxis? They are regulated and everyone had the choice at any airport to either use sub-optimal public transportation – particularly in Paris – or being ripped-off by a cab –particularly in Paris for tourists.

Remember when the meter was working, at the end of the trip some additional surcharges never listed were added and you couldn’t pay with a credit card and you had to be grateful for being carried to your final destination… Thanks to Uber and its digital competitors – Chauffeur privé in France, Lyft in the US – this is not the case any longer and I can now enjoy being driven where I want, when I want under the computerised fastest trip for a pre-agreed amount taken directly out of my credit card. No more fuss! And even airline companies are offering their check in clients to book a car to pick them up at the airport[1].

This is a testimony that taxi regulators worldwide were more interested in maximising taxi profits – which were mostly understated, thanks to to cash income – than in their customers' experience. And the unintended consequence is that people like me will no longer use a taxi if an unregulated cheaper, safer, easier-to-use, friendlier service is available.

Unfortunately for all regulators anywhere; extensive literature[2] and news in most countries suggest that regulators failed to push the regulated industry to be cost efficient and customer friendly. The effect has been a tendency to support investors more than consumers. This is particularly true with gas, where we are used to been over-charged for appalling regulated services – try to get your 40-year old energy meter changed by the regulated company and if you succeed let me know how much you were charged!

But what is more striking is that most regulators[3] seem not to notice the impact of Uber on taxis and to live on another planet, stuck with 1970 technology, where customers accept paying higher and higher fees for a poorer and poorer service with no economic justification… Until someone comes with an innovative, cheap and unregulated solution.

A recent example comes from the relatively new Ukrainian energy regulator[4]. According to a presentation by Naftogaz given during the Ukrainian Energy Day in London in June 2017, the new Regulated Asset Base (RAB) entry/exit tariff for transiting Russian gas in Ukraine should be $57.7/'000 m³ or $1.63/mn Btu on a capacity basis, instead of the actual average fee of $28/'000 m³ or $0.79/mn Btu on flow basis.

That system provided Naftogaz with $2.3bn revenues in 2016 for 82.2bn m³ transited. The result is the highest on the National Energy and Utilities Regulatory Commission website[5] and Naftogaz annual reports[6] with now the addition of VAT for transmission service. With this new “RAB approach, the Ukrainian TSO is eligible for additional $4bn/year for transit services until 2020”; looks a bit like my undisclosed cabbie surcharges added at the end of the trip…

But without discussing the unknowns[7] and taking this new “2017 RAB tariff”[8], let’s assume that the Russian and the European Union (EU, assumed as one zone) regulators want the same magic formula as Ukraine and all charge the same “2017 RAB tariff” of $1.63/mn Btu on a capacity entry/exit basis.

This fantastic regulation will charge 3 x $1.63 = $4.9/mn Btu for transporting Russian gas into/across EU, when the Dutch hub price (TTF) in June was below $4.9/mn Btu and US Henry Hub at $3/mn Btu. This is now becoming even worse than my old rip-off cab ride.

In short, the Ukrainian regulator with the help of the Energy Community Secretariat back-calculated the transit fee for Gazprom to be loss making on its gas production unless prices in Europe are moving up to a minimum of $5.7$/mn Btu[9] – and if EU gas demand goes down, this means that on a flow basis, the cost of transmission is going up, hence prices would go up.

Luckily in Europe, the European Commission (EC) is rightly trying to reduce transportation fees[10], where national energy regulators have failed. The EC has form in this regard, having scrapped all roaming charges for telecom companies inside the EU. The energy markets designed by the EC to allow anyone to compete help us get the best deals. If Ukraine believes that transit should be regulated with extremely high fees, we customers have other alternatives – other routes and/or LNG and/ or other fuels.

Natural monopolies’ regulations failed in most cases, as discussed earlier. But as the lines between competition and monopoly are blurring, the Ukrainian gas regulator like the taxi regulators are pushing to find alternative solutions. In our new world where energy prices are lower for longer, the Ukrainian expensive “2017 RAB tariff” could just fast-track gas demand destruction in Europe as higher gas prices will prompt coal switching and/or renewable growth… or foster Nord Stream 2 investment, that could be viewed like Uber: providing an efficient, safe and cheap alternative to a rip-off old cab ride.

The regulatory instability – as seen in Norway with a squeeze in margins and in Ukraine with an increase or potentially to come in the UK post-Brexit – shows that a “no risk world” doesn’t exist and that regulation should be limited to specific issues, and when some unforeseen competition emerges, the regulator should step down. Like the taxi regulators that are killing the taxi industry and allowing Uber and its competitors to state that they offer “the most affordable ride in town”, the Ukrainian gas regulator is providing the best equity story for Nord Stream 2 and for renewable energy. Was this Kiev's intention?

Finally, Uber is passing some of its cost-cutting to its customers. In the short term, it won’t cost Gazprom much more to operate Nord Stream 1 at full capacity vs the regulated cap set in the past[11] but it would allow Gazprom to reduce transit flows via Ukraine and fees to Naftogaz (for 10bn m³ less transit via Ukraine[12], the discount should be $0.8bn). So, with Nord Stream 1 operating at full capacity in the months to come, who should get the benefit of this lower Ukrainian transit fee: Gazprom or its customers? Hopefully informed markets could push spot prices a bit lower for the benefit of consumers.

 

Thierry Bros

Thierrybros.com

 



[1] Air France provides for example this worldwide service via Blacklane.

[2] One of the best pieces is “Regulatory Reform and The System Operator Model” by Prof. Dieter Helm available on http://www.dieterhelm.co.uk/regulation/regulation/regulatory-reform-and-the-system-operator-model/

[3] Ofgem the UK energy regulator recognised, in July 2017, that “energy networks should prepare for tougher price controls”  https://www.ofgem.gov.uk/publications-and-updates/energy-networks-should-prepare-tougher-price-controls

[4] An academic paper “Has Ukraine scored an own-goal with its transit fee proposal?” was published by Oxford Institute for Energy Studies in November 2016 with 2015 data with the conclusion “It would now seem that Naftogaz may also be forced to adapt to new realities and to react to competitive pressure by reviewing its transit fee strategy, potentially even reducing its transit fees”; available on https://www.oxfordenergy.org/publications/ukraine-scored-goal-transit-fee-proposal/

[5] http://www.nerc.gov.ua/?id=18343

[6] In 2016 “For the entry points, the rate is $12.47/'000 m³; the exit tariff is different for different exit points, the average tariff is $30.35/'000 m³”(page 86)  while in 2015 “The tariffs for all entry points to the gas transmission system of Ukraine are at the same level of $12.47/'000 m³ while there are different tariffs for various exit points ranging from $16.74/'000 m³ to $32.80/'000 m³.” (Page 195).

[7] It could be argued that Ukraine wants to increase its transit fees to strengthen its position in front of the Stockholm arbitration tribunal but this cannot be done via regulation as regulators are not there for this. Page 195 of Naftogaz 2015 annual report states “Pending the decision of the Arbitration Institute of the Stockholm Chamber of Commerce, the group applies gas transmission tariffs to Gazprom as set in the current contract on gas transit.”

[8] Ukraine transport profit margins were 45% in 2015 and 34% in 2016. Just for comparison, a recent Norwegian judgment ruled in favour of a maximum return of 7% for Norway transportation http://njordgasinfra.no/wp-content/uploads/2017/07/20170630-Verdict-Borgarting-Court-of-Appeal-Official-translation.pdf

[9] The cost of production in Russia (incl. the Russian Mineral Extraction Tax) is $0.8/mn Btu on average.

[10] The EU Commission tender “Quo Vadis, EU gas market regulatory framework – Study on a Gas Market Design for Europe” is looking at ways to improve overall efficiency in the gas business hence welfare for EU citizens.

[11] 43.7bn m³ in 2016 according to Naftogaz 2016 annual report page 71

[12] Nord Stream 1 nameplate capacity is 55bn m³/yr but has already operated at up to 61bn m³/yr. So, the revenues at risk for Naftogaz could be up to $1.2bn out of the $2.3bn received in 2016.