Infrastructure investments and incentive regulation. Juan Rosellón

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1 Infrasrucure invesmens and incenive regulaion Juan Rosellón

2 References Vogelsang, I., (2001), Price Regulaion for Independen Transmission Companies, Journal of Regulaory Economics, vol. 20, no. 2, Sepember. Rosellón, J. and J. Halpern, (2001), Regulaory Reform in Mexico s Naural Gas Indusry. Liberalizaion in he Conex of a Dominan Upsream Incumben, Policy Research Working Paper, The World Bank, 2537, January. Brio, D. L. and J. Rosellón, (2002), Pricing Naural Gas in Mexico; An Applicaion of he Lile Mirrlees Rule, The Energy Journal, Vol. 24, No. 3. Ramírez, J.C. and J. Rosellón, (2002), Pricing Naural Gas Disribuion in Mexico, Energy Economics, Vol. 24, No. 3, pp Brio, D. L. and J. Rosellón, (2003), Regulaion of Gas Markeing Aciviies in Mexico, Esudios Económicos, Vol.18, No.1 January-June. Brio, D. L. and J. Rosellón (2005), Price Regulaion in a Verically Inegraed Naural Gas Indusry: The Case of Mexico, The Review of Nework Economics, vol. 4, issue 1, March. Brio, D. L. and J. Rosellón, (2005), Sraegic Behavior and he Pricing of Gas in Mexico, in Repsol YPF-Harvard Kennedy School Fellows Research Papers William Hogan, edior, Cambridge, MA, Kennedy School of Governmen, Harvard Universiy, April, hp:// Brio, D. L. and J. Rosellón, (2005), Implicaions of he Elasiciy of Naural Gas in Mexico on Invesmen in Gas Pipelines and in Seing he Arbirage Poin, in Repsol YPF-Harvard Kennedy School Fellows Research Papers, William Hogan, edior, Cambridge, MA, Kennedy School of Governmen, Harvard Universiy, April, hp://

3 Conens Regulaory reform process of he naural gas indusry Incenive regulaion conceps Incenive regulaion and is effecs on infrasrucure invesmen: Disribuion Transporaion Producion Conclusions

4 Regulaory reform process of he naural gas indusry

5 REGULATORY REFORM Make Pemex inves more in producion and developmen of reserves, and keep in good shape he already exising pipeline ransporaion nework. Arac privae invesmen o develop infrasrucure in disribuion sysems, new ransporaion pipelines as well as in gas markeing. All hese hrough a regulaory-reform process ha implied regulaory decisions regarding indusrial srucure and incenive regulaion (prices, aucions, ec.).

6 Producion and reserves Naural Gas Producion (Reserves) by Zone 1997 Marine Zone 36.9% (17.5%) Norh Zone 17.3% (57.1%) Souh Zone 45.8% (25.4%)

7 PIPELINE SYSTEM Impors Impors Cananea Imuris Naco Hermosillo Guaymas Cd. Cuauhémoc Cd. Juárez Chihuahua Delicias Gómez Palacio Cd. Camargo Jiménez Laguna del Rey Torreón Monerrey Impors Nuevo Laredo Monclova Salillo Linares Impors Impors Piedras Negras Los Ramones Reynosa Maamoros Argüelles Sn. Fernando Burgos Sn. Luis Poosí Cd. Madero Guadalajara Salamanca Morelia Uruapan L. Cárdenas Sa. Ana Toluca Tula Tlalchinol Pachuca Puebla Jalapa Poza Rica Veracruz Maapionche Pajarios T. Blanca Minailán Mérida Campeche Villahermosa La Vena Aasa Cd. Pemex Nvo. Teapa In Operaion Ou of Service Injecion Poin Source: PEMEX Salina Cruz Cacus y Nuevo Pemex

8 Indusry Srucure Before 1995 SUPPLY TRANSPORTATION DISTRIBUTION DEMAND Oil and Gas Wells Processing PEMEX GAS Transporaion aciviies Pemex Privae LDC S Sae Owned LDC S ººº º º º ººººººººº ººº º º º ºººººººº Small Users Indusrial Commercial Residenial Large Users CFE PEMEX Peroquímica Indusry Compeiion from oher fuels Expors Impors Source: Pemex- Gas y Peroquímica LEGEND ºººººººººººººº Supply Transporaion Disribuion Aciviies reserved o Pemex

9 SUPPLY Expeced Evoluion TRANSPORTATION DISTRIBUTION DEMAND PEMEX GAS Transpor ******************** ******************** * * * * * * Sorage LDC S ººººººººººººººº ºººººººººººº º º º ºººº Small Users Indusrial Commercial Residenial Large Users Compeiion from oher fuels CFE PEMEX Peroquímica Indusry Trading Impors Expors Source: Comisión Reguladora de Energía DESCRIPTION Supply Transporaio Aciviies reserved o Pemex ************* ºººººººººººººº Sorage Disribuion Trading

10 Policy decisions EXCLUSIVITY Transporaion: no exclusiviy. Disribuion: Twelve-year exclusiviy for each LDC projec. Commercial bypass from day one. Physical bypass gradually implemened. INTERNATIONAL TRADE Any person can impor naural gas wihou impor license. Eliminaion of he impor ariff

11 VERTICAL INTEGRATION Verical inegraion beween ransporaion and disribuion: only when a ransporaion permi is necessary for a disribuion projec or vice versa. Producers, ransporers, operaors of sorage faciliies and disribuors can be markeers. All verical inegraions permied providing here is one subsidiary for each aciviy. Subsidiaries a arm s lengh. Unbundling.

12 MARKETERS Markeers need no permi o operae. Markeers can buy gas and sell i o disribuors or consumers conneced o he ransporaion sysem. Markeers can sell gas o consumers wihin he disribuion area. Markeers can buy and sell pipelines capaciy (secondary marke). PIPELINE ACCESS Open access o ransporaion and sorage. Disribuion: Commercial bypass from day one

13 Naural Gas Producion (Reserves) by Zone 2005 Marine Zone 34% (28.1%) Norh Zone 33.4% (28.3%) Souh Zone 32% (43%)

14 Demand Mexican Naural Gas Consumpion Elecriciy Generaion 22% Residenial and Commercial Cusomers 6% Pemex 42% Indusry 31% Mexican Naural Gas Consumpion Elecriciy Generaion 36% Residenial and Commercial Cusomers 1.85% Pemex 40% Indusry 22%

15 BASE SCENARIO OF CONSUMPTION AND NET PRODUCTION Thousand of cubic meers per day 350, , , , , ,000 50, ELECTRIC OIL INDUSTRIAL RESIDENTIAL AND SERVICE VEHICLE Toal Supply

16 Table 7 Characerisics of Naural-Gas Disribuion Permis Concessionaire Locaion Graning Dae Lengh* (km) Capaciy mm3/d Users Coverage DGN de Mexicali, S. de R.L. de C.V. Cía. Nacional de Gas, S.A. de C.V. DGN de Chihuahua, S. de R.L. de C.V. Gas Naural México, S.A. de C.V. (Salillo) Gas Naural del Noroese, S.A. de C.V. Gas Naural México, S.A. de C.V. (Toluca) Cía. Mexicana de Gas, S.A. de C.V. Gas Naural México, S.A. de C.V. (Nuevo Laredo) Gas Naural de Juárez, S.A. de C.V. Gas Naural del Río Pánuco, S. de R.L. de C.V. Tamauligas, S.A. de C.V. Mexicali 27/09/ , Piedras Negras 20/03/ , Chihuahua 20/05/97 1, , , Salillo-Ramos 20/06/ , Arizpe-Areaga Hermosillo 9/06/ , Toluca 3/09/ , , Monerrey 9/09/ , , Nuevo Laredo, 17/11/ , Tamaulipas Ciudad Juárez 2/12/97 1, , Río Pánuco 19/12/ , , Nore de Tamaulipas 27/03/ , ,447.00

17 Table 7 Characerisics of Naural-Gas Disribuion Permis Concessionaire Locaion Graning Dae Lengh* (Km) Capaciy mm3/d Users Coverage Invesmen* (US$ Million) Gas Naural México, S.A. de C. V. (Monerrey) Disribuidora de Gas Naural del Edo. de México, S.A. de C.V. Consorcio Mexi-Gas, S.A. de C.V. Disribuidora de Gas de Queréaro, S.A. de C.V. Gas Naural México, S.A. de C.V. (Bajío) DGN la Laguna-Durango, S. de R. de C.V. Disribuidora de Gas de Occidene, S. A. de C.V. Monerrey 24/04/98 7, , , Disrio Federal 3/09/98 2, , , Valle Cuauilán- 3/09/98 3, , , Texcoco Queréaro 10/12/ , , Silao-León- Irapuao 15/01/ , , Torreón-Gómez 18/06/99 1, , , Palacio-Ciudad Lerdo-Durango Cananea, Sonora 9/08/ , Puebla-Tlaxcala 28/01/ , , Gas Naural (Bajío Nore) Bajío Nore 22/02/ , , Toal 23, , ,035, (*) A he fih year of he permi. Source: Comisión Reguladora de Energía.

18 Incenive regulaion conceps

19 Few marke niches wih legal or naural monopolies (e.g.: ransmission and disribuion of naural gas and elecriciy). Regulaion of monopolies is imporan since hey are verically inerrelaed wih oher compeiive secors.

20 HISTORY OF OPTIMAL PRICES Firs Bes: marginal cos (70 s). Second bes: Ramsey prices (80 s). Third bes: Revelaion principle/laffon-tirole (93). Fourh bes: Theoreical models under pracical resricions (nowadays).

21 DESIRABLE PROPERTIES OF APPLIED MECHANISMS Pareo superioriy. Efficiency improvemens. Two basic conceps: - Price level. - Price srucure.

22 Price-level regulaion ALTERNATIVES Cos-of-service regulaion. Price caps. Adjusmen facors (RPI, X, ec.). Yardsick regulaion. Hybrid regulaion.

23 Price-srucure regulaion ALTERNATIVES Fully disribued cos pricing. Price bands. Resriced flexibiliy: - Average revenue. - Tariff baske.

24 AVERAGE REVENUE REGULATION Ses a cap on revenues per uni. Does no se fixed weighs ha limi ariff rebalancing. TARIFF-BASKET REGULATION Cap se over an index. Fixed weighs I(p) = h i= 1 w i p i

25 TYPES OF WEIGHTS Chained Laspeyres. Paasche weighs. Fixed Laspeyres. Ideal weighs. Flexible weighs (average revenue).

26 POLICY OPTIONS Price level regulaion: Cos of service or incenive regulaion? Price srucure regulaion: Tariff baske or average revenue?

27 INCENTIVE REGULATION Promoes producive and allocaive efficiency. Ligh-handed regulaory inervenion. Capures virues of boh price cap and cos of service mehodologies: - Limis firm s risk. - Provides incenives for cos reducion. - Proecs consumers.

28 Incenive regulaion and is effecs on infrasrucure invesmen Disribuion

29 The regulaory reform process in disribuion combined he design of aucions for exclusiviy in disribuion geographical areas (compeiion for he marke), as well as incenive regulaion for disribuion ariffs, so as o arac invesmen. Aucion design sough o reach a balance in he rade-off beween risk managemen (hrough he graning of exclusiviy) and incenive provision (implici compeiion beween he LDCs and Pemex). The design of price regulaion ried o reach equilibrium in he rade-off beween invesmen aracion o greenfield projecs (average-revenue incenive regulaion) and consumer-surplus maximizaion (hrough ariff-baske incenive regulaion and compeiion for he marke).

30 CRE S PLAN Compeiion for he disribuion marke. Greenfield projecs. Biddings gran 12-year disribuion exclusiviy. Average-revenue regulaion used during he firs five-year period. Tariff-baske is used laer on. Prices mus be se a he sar of he period based on a forecas of Q. Need of a correcion facor o adjus for esimaion errors. Average revenue regulaion provides he needed flexibiliy in ariff rebalancing during he iniial sages of greenfield projecs.

31 LITERATURE REVIEW. THREE RESULTS 1. Under sable cos and demand funcions, and myopic profi maximizaion he chained Laspeyres index induces convergence o Ramsey prices. 2. Assuming sable cos and demand funcions, and myopic profi maximizaion, average revenue regulaion causes divergence from Ramsey prices. 3. In a dynamic seing wih changing cos and demand funcions --and/or non-myopic profi maximizaion-- he chained Laspeyres index generaes prices ha may diverge from he Ramsey srucure.

32 LITERATURE REVIEW: POLICY RECOMMENDATIONS - Chained Laspeyres index should be used under cos and demand sabiliy. - Under risk and uncerainy here is no reason ha jusifies he use of he Laspeyres index. - Average-revenue regulaion is a sofer consrain han he chained Laspeyres index. I helps o arac invesmen. - Under changing demand condiions, wha are he effecs of average-revenue regulaion on consumer surplus?

33 The Model Ramírez, J.C. and J. Rosellón, (2002), Pricing Naural Gas Disribuion in Mexico, Energy Economics Under changing demand condiions, wha are he effecs of average-revenue regulaion and compeiion for he disribuion marke on consumer surplus? Two effecs: sraegic effec and sochasic effec. Soluion: se usage charge close o zero while fixed charge sraegically se o bear burden of mispredicion. Sochasic effec alone: Consumer surplus decreases (increases) as he firm is more risk loving (averse) and when here is less (more) demand uncerainy.

34 Average-Revenue Consrain Saic consrain: p / Q i ( p i ) p i p0 Q i ( p i ) i i Dynamic consrain: AR = p + E( AR F ) = E( Q ) F Q p + F E( Q [ M p ] ) M

35 DYNAMIC CONSTRAINT M = K + +1 M M = M 0 + k k 1

36 DYNAMIC CONSTRAINT K will be posiive, zero or negaive whenever AR < M, AR = M or AR >M, respecively. The sraegic effec: [ ] E(Q ) = Q : F Q M p

37 DYNAMIC CONSTRAINT The sochasic effec: Q sochasic E(Q ) Q AR M K 0 and, herefore, more (or less) flexibiliy o se F +1.

38 The Sochasic Model + = T F p F Q c Q p E max 1, ) ) ( ( β K p Q Q = + ) ( 1 subjec o { } ) ( p M Q E F N Q T [ ] 0,1 β

39 SOLUTION Saic scenario: se he usage charge P close o zero and se fix charge F o he level ha saisfies he average-revenue and cumulaive consrains. Dynamic scenario wih sraegic pricing: The usage charge in period (P ) is kep close o zero while he fixed charge in period +1 (F +1 ) is sraegically se so as o bear all he burden of mispredicion

40 SOLUTION Dynamic scenario wih no sraegic pricing: he saic-case soluion is applied in each period. However, we proceed o isolae he effec of he sochasic effec alone on consumer surplus. We assume he fixed fee is kep consan in each period and sudy how he firm manipulaes is expeced profis subjec o he average revenue and cummulaive consrains, and under he sochasic behavior of he correcion facor K.

41 SIMULATION + = T p cp F bp a M E max 1 ] [ ] [ ( β subjec o K bp a Q = +1 N Q T

42 SIMULATION RESULTS Resuls obained under he assumpion of no sraegic behavior. Consumer surplus ends o decrease (increase) as he firm is more risk loving (averse) and when here is less (more) demand uncerainy.

43 Incenive regulaion and is effecs on infrasrucure invesmen Transporaion

44 A regulaory scheme ha provides incenives for he developmen of he ransporaion nework is been sough. A firs srucural basic problem is of course Pemex verical disinegraion. Pemex has incenives o conges he pipeline nework so as o ge congesion rens, evade price regulaion, and deer he enrance of compeiors in gas markeing aciviies. In he case of verical disinegraion, several incenive regulaory alernaives are analyzed so as o arac privae invesmen. Two proposals: - Brio, D. L. and J. Rosellón, (2005), Implicaions of he Elasiciy of Naural Gas in Mexico on Invesmen in Gas Pipelines and in Seing he Arbirage Poin, in Repsol YPF- Harvard Kennedy School Fellows Research Papers, William Hogan, edior, Cambridge, MA, Kennedy School of Governmen, Harvard Universiy, April, hp:// - Vogelsang, I., (2001), Price Regulaion for Independen Transmission Companies, Journal of Regulaory Economics, vol. 20, no. 2, Sepember.

45 FIRST PROPOSAL Sufficien invesmen in pipeline capaciy so ha bolenecks do no develop. A policy ha makes sure ha here is always sufficien pipeline capaciy so ha he gas marke can always clear should be followed. Such a policy would generae sufficien savings o he consumers of gas ha hey will be willing o pay for such invesmen in he rae srucure. Consumers would be willing o pay for his capaciy.

46 p p M a p M b c e λ D(p) Q Qe λ Q

47 γ 1 =1 γ 2 =1 γ 1 =0.1 γ 2 =1 γ 1 =0 γ 2 =1 rae of reurn γ 1 =0 γ 2 = weeks

48 Pipeline capaciy WELFARE LOSS FUNCTION F.O.C. ( ) ( ) [ ] ( ) [ ] + + = T rt M M r C e d p Q e Q p Q e e Q e ϕ γ θ γ θ ϕ λ λ λ ( ) ( ) [ ] ( ) [ ] r C p Qe Q p Qe Q e M T M T T = ϕ γ θ γ θ λ λ λ

49 SECOND PROPOSAL Vogelsang s suggesion for regulaing price srucure in elecriciy ransmission considers congesion problems (shor run) and capaciy problems (long run). Two-par ariff cap: - Usage fee solves congesion problems. - Fixed fee recovers capial coss. - Rebalancing beween usage fee and capaciy fee provides invesmen incenives. - Transmission quaniies are used as weighs.

50 VOGELSANG S MODEL subjec o: ), ( k q c N F q p max + = + + j w j j w i i i w j j j w i i i X F q p F q p ) 1 )( ( 1 1 δ δ ( ) N q p p F F w k q

51 Incenive regulaion and is effecs on invesmen Producion

52 Regarding naural gas producion, price regulaion seeks o provide incenives for producive efficiency by making Pemex anoher compeior in he Norh American naural gas markes. However, his regulaion presens a problem in is srucure of incenives. Pemex has incenives o decrease invesmen in gas producion and processing, o flare gas, and o deviae producion from he regulaed marke o is own inernal marke (so as o bring down he arbirage poin). Likewise, Pemex has incenives o conges is ransporaion pipelines so as o increase he domesic naural gas price as well as o sraegically use he pipeline capaciy o preserve is monopoly in gas markeing and evade he neback price regulaion.

53 The proposed regulaory measures o deal wih hese problems are: Close regulaory monioring of Pemex producion, processing and gahering (flaring) aciviies. Fixing he arbirage poin in he shor run. Pemex should be charged for he gas i uses and he gas i flares. Open acess o gas pipelines and invesmen in he nework. Pemex verical disinegraion or (a leas) no leing Pemex o marke gas inside Mexico.

54 The Lile-Mirrlees rule Lile and Mirrlees propose using he world prices for raded goods because hese prices reflec he erms under which a counry can rade. The pricing rule based on he Houson Ship Channel price is an implemenaion of he Lile-Mirrlees proposal. The price of gas in Houson is he opporuniy cos of using gas in Mexico raher han exporing i o he US

55 NETBACK FORMULA Price cap of Mexican naural gas: price in Souheas Texas plus ranspor coss from Texas o he arbirage poin less ranspor coss from he arbirage poin o Ciudad Pemex ARBITRAGE POINT Place where norhern and souhern gas flows mee Price of norhern and souhern gas is he same I moves norh (souh) as impors decrease (increase) Currenly locaed a Los Ramones

56 The Model Brio, D. L. and J. Rosellón, (2002), Pricing Naural Gas in Mexico; An Applicaion of he Lile Mirrlees Rule, The Energy Journal, Vol. 24, No. 3. Effecs of invesmen in producion faciliies, and echnical expor resricions on naural gas pricing Implicaions of he regulaory framework on Pemex markeing aciviies Forward markes and pipeline capaciy MAJOR RESEARCH FINDINGS Neback formula derives from he soluion of he problem of a regulaor ha maximizes welfare subjec o resource consrains in he pipeline nework. Neback formula is an applicaion of he Lile-Mirrlees principle, and relies on he fac ha he Houson hub is has a compeiive marke. The formula can also lead o incenives o increase he price of domesic naural gas by divering producion from he regulaed marke. Opimal o develop new gas sources closes o he arbirage poin raher han o he cener of consumpion

57 MAJOR RESEARCH FINDINGS The neback policy is criically condiional on he exisence of adequae pipeline capaciy. If here is insufficien capaciy, he movemen of gas will no clear markes and i will be impossible o implemen he neback rule. Pemex should no be permied o discoun he price of gas from he Houson neback price because i can carry ou several sraegies (such as cross subsidies) and evade regulaion. In an open economy where agens can chose beween gas and alernaive fuels he neback rule is Pareo opimal. There is evidence ha pipeline nework capaciy resricions in Texas preclude he arbirage beween he LNG impor price and he Houson naural gas price. Therefore, he use of a ne presen lower benchmark price migh be jusified.

58 RESEARCH TRANSLATED INTO POLICY ANALYSIS Open access regulaion as well as he monioring invesmen in pipeline capaciy PEMEX verical disinegraion Shor-erm regulaory measures o provide PEMEX incenives o increase supply in he domesic regulaed marke include fixing he arbirage poin a a level ha forces Pemex o increase producion and invesmen, and seing a price based on he neback rule for inernal gas ransacions among PEMEX subsidiaries. The use of he Souh Texas price relies on he assumpion of compeiive condiions in he Texas naural gas marke. The recen increasing rend in he gas price and he expeced fuure increase of LNG migh give reason for he use of an alernaive benchmark price.

61 Choice variables: expors (Y b ), impors (Z b ), amoun of consumpion, and he arbirage poin Variables of ineres: he arbirage poin, price of gas a Burgos (p b ) and Ciudad Pemex (p c )

62 Maximize subjec o

64 Conclusions

65 MAIN LESSONS The policy design of incenive regulaion o arac invesmen should consider he effecs of indusry-srucure and verical inegraion decisions on defining a level playing field for all marke players. Decisions on price regulaion should consider reaching equilibrium in a leas wo rade-offs: 1. Risk managemen vs. Incenives 2. Invesmen aracion vs. Consumersurplus maximizaion.

Projected Supply and Demand for Natural Gas over the next 10 years and Plans for Major LNG Receiving Terminals March 11, 2003 Houston, Texas

2 nd Annual LNG North America Conference Projected Supply and Demand for Natural Gas over the next 10 years and Plans for Major LNG Receiving Terminals March 11, 2003 Houston, Texas Index I. Regulatory